Does Cancellation Of Debt Income Increase Basis

Counterfoil of Debt Ramifications & Relief to Real Manor Partnerships

In general, the cancellation of debt (COD) results in the recognition of taxable income under Internal Revenue Code (IRC) §61(a)(eleven) as a "discharge of indebtedness." The amount of gross income recognized equals the divergence between the confront value of the debt and the fair market value (FMV) of whatever property or money paid in satisfaction of that debt. However, IRC §108(a) allows certain discharges of debt to avert gross income nomenclature. These particular discharges run the gamut from legal determinations, such as Affiliate 11 bankruptcy or insolvency, to the nature of the indebtedness, such as qualified farm indebtedness or qualified master residence indebtedness. This article will narrowly focus on the implications of COD for real estate partnerships and their partners. Thus, particular attention will be paid to the gross income exclusion resulting from the belch of qualified real property business indebtedness (QRPBI).

If a partnership recognizes COD income, it volition allocate that income among its partners. Under IRC §705(a), a partner'due south basis increases by the allocated COD income. Further, in accordance with IRC §752(b), the reduction in the debt through discharge will also lead to a subtract in a partner'south share of allocated debt. IRC §752(b) treats this decrease in liabilities as a distribution of greenbacks to the partner that results in a decrease in basis.

Instance : Meredith owns a x% interest in Partnership 10. Partnership X has a single debt with outstanding master of $20,000,000. Meredith has a revenue enhancement basis in her partnership interest of $3,000,000 which includes her x% share of the Partnership Ten debt ($two,000,000 = 10% x $20,000,000).

The lender forgives $five,000,000 of the debt. Thus Partnership X will recognize $5,000,000 in COD income, 10 percentage of which it will allocate to Meredith. Meredith'south allocable share of the Partnership X debt will too drop accordingly. She will compute the tax basis of per Partnership 10 interest every bit follows.

For a real estate partnership, most COD volition not result in gross income to the partners due to the exclusion for QRPBI provided nether IRC §108(a). QRPBI is defined under IRC §108(c) as debt meeting the following requirements:

Incurred or assumed past the taxpayer in connection with real property used in a trade or business and secured by the real property.
Incurred or assumed before January i, 1993, or if incurred on or after such date, is a qualified acquisition indebtedness meaning debt incurred to acquire, construct, reconstruct, or substantially improve the real property. This includes debt resulting from the refinancing to the extent it does not exceed the corporeality of indebtedness being refinanced.
The partner elects to apply the QRPBI exclusion on the Federal income tax return for the tax year in which the discharge of indebtedness occurred.

IRC §108(c) also describes the allowed amount of excludable discharged debt. Specifically, the corporeality excluded cannot exceed the difference between the outstanding master residue of the debt prior to the discharge and the FMV of the existent holding (an amount farther reduced by the outstanding chief amount of any other QRPBI secured by the property). Additionally, the amount of debt canceled cannot exceed the aggregate adjusted bases of depreciable real holding held by the taxpayer prior to the cancellation.

Example : A partnership owns, leases, and manages an office building. The partnership originally purchased the office edifice for $five million. The partnership however owes $2,500,000 in principal on the holding. Due to a downturn in the existent estate market, the FMV of the part building has fallen to $2,000,000. The lender agrees to forgive $700,000 of the amount outstanding. As a event, the partnership tin exclude the difference betwixt the remaining chief on the mortgage and the FMV of the property. And so information technology tin can exclude $500,000 ($two,500,000 – $2,000,000) from gross income. Withal, the partnership must recognize the remaining $200,000 ($700,000 – $500,000) forgiven every bit COD income. The $500,000 COD non recognized decreases the partner's footing creating more proceeds on whatever later sale/liquidation of his partnership interest.

The canceled amount of debt eligible to exist excluded from the income of a partner results in the adjustment to the footing of his or her partnership interest. If the partner elects to exclude his/her share of COD income due to the QRPBI exclusion, the partner's involvement would be reduced by his/her share of the income excluded. The partnership will make a corresponding reduction in bases in its assets creating a special basis for simply this partner similar to an IRC §743(b)(two) stepdown in assets. If a partner elects not to exclude their share of COD income, the partner's interest would exist increased by the amount of COD income recognized with no corresponding adjustment in the bases of avails past the partnership.

The Internal Revenue Service'southward Individual Letter of the alphabet Ruling (PLR) 9840026 goes further in specifically addressing the QRPBI in the context of a partnership. This PLR addressed the restructuring of debt resulting from the negotiation between the partnership and the lender. Specifically, the partnership endemic and operated an apartment complex. The partnership performed all managerial and maintenance work as well as paid all bills, collected rent, procured insurance coverage, and obtained all necessary licenses and permits. In analyzing the constabulary applicable to the above ready of facts, the PLR noted the post-obit:

At the partner level:
- the ballot to exclude COD income occurs.
- reduction in any tax attributes (i.e. partner's ground increased/reduced) is made.
At the partnership level:
- the conclusion of whether debt meets the definition of QRPBI is adamant.
- the calculation of the exclusion limitation is made.
For purposes of the QRPBI exclusion, a triple cyberspace lease does not ascent to the level of a trade or business. In a triple net lease, the tenant has the sole responsibility of maintaining the holding, paying the property taxes, and acquiring insurance.
The excluded COD income reduces the basis of a partner'due south interest to the extent of a corresponding proportionate reduction in the basis of the partnership's depreciable real holding with respect to that partner.

The PLR concluded the partnership used the existent property in a merchandise or business thus allowing the partners, on a partner-by-partner ground, to elect to use the QRPBI exclusion.

Instance : Paul owns a l% interest in Partnership APT. Anne owns the remaining 50% involvement. Partnership APT owns and operates an flat complex. The flat building has a FMV of $5,000,000 and an adjusted tax basis of $4,000,000. Partnership APT owes $six,200,000 in principal on a loan secured past the building. The lender forgives $ane,000,000 of the outstanding principal.

Therefore, Partnership APT realizes $1,000,000 in COD income. The partnership COD exclusion limit equals $1,200,000 (= $half dozen,200,000 – $5,000,000) which exceeds the $ane,000,000 of discharged debt.

Partnership APT allocates $500,000 in COD income to Paul. Paul elects to exclude the COD income. Partnership APT will therefore reduce its basis in the building with reference to Paul'southward l% interest in the building or by $500,000 to $iii,500,000. Paul volition too reduce the basis in his partnership interest by $500,000.

Anne chooses non to elect to exclude the COD income. She will therefore recognize $500,000 in COD income and Partnership APT will accordingly not further reduce the tax basis of the building.

For more information on the impact of the COD in the context of a real estate partnership, please contact one of our experienced CPAs or revenue enhancement professionals at Kurtz & Company, P.C.