Recognition of COD Income Realized on Satisfaction of Debt with Partnership Interest

A corporation that transfers shares of its stock in satisfaction of its debt must recognize cancellation of debt (COD) income in the amount that would be realized if the debt were satisfied with money equal to the stocks fair market value (FMV). For a partnership that transfers a capital or profits interest in the partnership to a creditor in satisfaction of its debt, no Code provision expressly requires the partnership to realize COD income.

New Law

Under AJCA Section 896, when a partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of partnership debt, the partnership generally recognizes COD income in the amount that would be recognized if the debt were satisfied with money equal to the FMV of the partnership interest. The provision applies without regard to whether the cancelled debt is recourse or nonrecourse. Further, any COD income so recognized is allocated to the partners who held interests in the partnership immediately before satisfaction of the debt.

Effective Date

This provision is effective for CODs occurring after Oct. 21, 2004. Committee Reports indicate that no inference is intended as to the treatment of such transactions under present law.

Implications

This change is likely to cause severe adverse tax consequences in many real estate debt workouts. COD income may exist regardless of the solvency of the partnership, as the test focuses on the value of the equity provided. One example of a solvent partnership falling under this rule could be a situation in which the FMV of the equity interest exchanged is less than the face amount of the debt, due to a change in market interest rates as compared to the interest rate used by the debt instrument. This rule only applies to COD income as it relates to the partnership and does not address the consequences to the creditor. Thus, it is possible that the creditors loss may be capitalized into the basis of the partnership interest that it receives.

From Steven Schneider and Robert Crnkovich, Washington, DC