Dispositions of Property in Satisfaction of Debt

A taxpayer considering transferring assets to settle a debt should carefully analyze the tax consequences before entering into such a transfer. A combination of gain from the deemed sale of the property and cancellation of debt (COD) income may result. Under certain circumstances, the taxpayer may qualify for tax-favored treatment, such as deferral or elimination of the COD income.

Background

According to Rev. Rul. 90-16, a taxpayer is treated as having sold or exchanged property when he or she transfers property to a creditor in discharge of debt, regardless of whether the transfer is a voluntary conveyance by deed or an involuntary foreclosure. The debts character (i.e., recourse or nonrecourse) determines the transfers tax consequences.

Recourse Debt

Regs. Sec. 1.1001-2 explains that if property is transferred to satisfy recourse debt, the transfer is divided into two transactions. The first transaction is the sale or exchange of the property. The amount realized is the loan amount, to the extent of the transferred propertys fair market value (FMV). The amount realized, less the propertys adjusted tax basis, results in the gain or loss.

The second transaction computes the COD income, which is the debt discharged in excess of the FMV of the property transferred.

Example 1: J owns property with a $40,000 basis that is subject to a $50,000 recourse debt. The propertys FMV is $20,000. J transfers the property to the creditor in satisfaction of the debt. His amount realized includes the $50,000 liability relieved, under Regs. Sec. 1.1001-2(a)(1), but is limited to the propertys $20,000 FMV. His basis is $40,000, so he has a $20,000 loss on the exchange ($20,000 realized $40,000 basis). J also has $30,000 of COD income ($50,000 debt $20,000 FMV) on the transfer.

Nonrecourse Debt

When property is transferred to satisfy a nonrecourse debt, the transaction is treated as a sale or exchange of the property transferred, under Regs. Sec. 1.1001-2(c), Example (7). The realized gain or loss is the difference between the amount realized and the taxpayers adjusted basis in the property; no COD income is realized. 

Example 2: The facts are the same as in Example 1, except that the debt is nonrecourse. Js amount realized is $50,000, but his realized gain is $10,000 ($50,000 amount realized $40,000 adjusted basis). There is no COD income.

Partially Recourse Debt

As explained in Letter Ruling 8348001:

When a debt is partially recourse and partially nonrecourse, it is reasonable to assume that a settlement of the debt, whether by the payment of a lump sum in cash or by a transfer of property, will first be allocated to the nonrecourse portion of the debt. Only if the amount of cash, or the value of property, exceeds the nonrecourse portion of the debt, should any of the settlement be considered as discharging the recourse portion.

If the FMV of the property transferred is less than the nonrecourse portion of the liability, the taxpayer will realize a gain or loss of the difference between the nonrecourse debt and the propertys basis. The taxpayer will recognize COD income to the extent that the total liability exceeds the nonrecourse portion. If the propertys FMV exceeds the nonrecourse portion of the debt, the taxpayer will have a gain or loss on the sale, as measured by the difference between the propertys FMV and basis. The taxpayer would have COD income to the extent the total debt exceeds the propertys FMV.

Example 3: The facts are the same as in Example 1, except that the $50,000 debt is $40,000 nonrecourse and $10,000 recourse. J transfers the property to the creditor in satisfaction of the debt. Js gain is zero ($40,000 nonrecourse debt $40,000 basis). He recognizes $10,000 of COD income ($50,000 total debt $40,000 nonrecourse debt). If the propertys FMV were $45,000, J would have a $5,000 gain ($45,000 FMV $40,000  basis) and $5,000 of COD income ($50,000 total debt $45,000 FMV).

Planning Opportunities

Sec. 61(a)(12) provides that gross income includes COD income, but Sec. 108(a)(1)(A) provides that a debtor in bankruptcy (title 11) may exclude COD income from gross income. Under Sec. 108(a)(1)(B), an exclusion from gross income is also available if the discharge occurs when the taxpayer is insolvent.

For recourse debt, one possible result is to end up with a capital loss and ordinary income. Because the tax results are affected by the propertys adjusted basis and FMV, a taxpayer with more than one property that could be used to satisfy debt can minimize the negative tax effect. In any case, accurate tax basis and appraisal of the properties are critical.

From Michael J. Mihelich, MST, CPA, Boyes Wright Pittman & Co., P.C., Farmington Hills, MI