Tax Court Decision Underscores Key Considerations in Real Estate Debt Workout Transactions

In a recent memorandum decision, the Tax Court has held that a taxpayer had Section 1001 gain or loss, and not cancellation of debt (COD) income, with respect to the sale of real property subject to a nonrecourse loan that was cancelled or retired as part of the sale transaction (Parker v. Commissioner, T.C. Memo 2023-104). 

This decision serves as a reminder of the importance of properly evaluating and structuring a debt workout transaction in light of possibly alternative federal income tax consequences. 

Based on the particular facts and circumstances, taxpayers may wish to consider whether such a transaction can be structured to generate COD income or Section 1001 gain. For example, a taxpayer may be eligible for one or more exceptions to the recognition of COD income under Section 108. Full or partial exclusion of COD income may be more beneficial than recognition of capital gain resulting from a Section 1001 transaction. Structuring a transaction to achieve either capital gain or COD income is complex with numerous pitfalls and traps for the unwary.

This Alert highlights several key tax considerations in evaluating these types of transactions. 

Tax Treatment of Recourse Versus Nonrecourse Debt

It is essential to understand the difference in the income tax treatment of retirement or cancellation of recourse versus nonrecourse debt as part of a sale or exchange of the underlying property collateral.

If the debt is nonrecourse, the gain will generally be Section 1001 gain or loss (generally capital gain or Section 1231 gain, assuming the real property collateral is not dealer property), rather than COD income, which is characterized as ordinary income.  

Conversely, if the debt is recourse, there will be COD income to the extent the debt balance exceeds the fair market value of the real property collateral, and Section 1001 gain or loss to the extent the fair market value exceeds (or falls short of) the adjusted tax basis in the property. 

Alternatively, if a nonrecourse loan is not retired but instead is substantially modified and assumed or taken subject to by the buyer, the transfer may trigger COD income that generally will be allocated to the seller under Reg. §1.1274-5(b).

Similarly, COD income can be generated from a substantial modification of a nonrecourse loan that is not part of a sale or exchange of the underlying real property collateral.

Gross Income Exclusions

COD income may qualify for one of several gross income exclusions under Section 108, e.g., the exclusion for qualifying real property business indebtedness under Section 108(c). Conversely, Section 1001 gain does not qualify for any such exclusion.

Determining Whether Debt Is Recourse or Nonrecourse

Determining whether a debt is recourse versus nonrecourse is not always easy. For this purpose, the Section 1001 regulations provide guidance as to whether a liability is recourse versus nonrecourse. When analyzing a partnership debt workout, the definition of recourse versus nonrecourse under Section 752 should generally not be used. 

In contrast to Section 752 where recourse versus nonrecourse is determined based on the partners’ economic risk of loss, the determination of recourse versus nonrecourse status under Section 1001 depends on whether the creditor’s rights are limited to a particular asset or group of assets. Recourse indebtedness for Section 1001 means all the debtor’s assets may be reached by creditors if the debt is not paid while nonrecourse indebtedness is where the creditor’s remedies are limited to the collateral for the debt. See Raphan v. United States, 759 F.2d 879 (Fed. Cir. 1985).  

Depending on the facts (e.g., a full recourse loan to a limited liability company with no guarantees by the LLC members or their affiliates), it may be unclear whether debt is recourse or nonrecourse for Section 1001 purposes. The Tax Court in Great Plains Gasification Associates v. Commissioner, T.C. Memo 2006-276, agreed with the IRS when it appeared to argue that Section 752 and the regulations thereunder determine whether partnership debt is characterized as recourse or nonrecourse. However, the IRS appeared to reverse its position in CCA 201525010, when it ruled that the implication created by Great Plains Gasification was erroneous. The IRS further stated that Section 752 is limited to determining the partners’ basis in the partnership. As primary authority for this conclusion, the IRS cites Reg. §1.752-1(a), which states that the definitions of recourse and nonrecourse liabilities found in this paragraph only apply “for purposes of Section 752.” In some cases, it may be possible to conclude that there is substantial authority for either position.

Planning Considerations

Taxpayers may prefer COD income to capital gain or vice versa depending on the taxpayer’s specific situation. For example, a taxpayer may prefer COD income if the taxpayer is insolvent, in bankruptcy, or otherwise eligible for another COD income exclusion. Another taxpayer who is eligible for the lower capital gains rates, but not eligible for a COD income exclusion, would generally prefer capital gain to COD income.  

There may be tax planning opportunities in these situations. Key factors to be considered include the following:

• Is there a preference for COD income over capital gain?
• Is any property being transferred as a result of the workout?
• Is the liability recourse or nonrecourse?

With careful and proactive planning, achieving desired results may be possible. For example, if the taxpayer would prefer COD income where the debt is nonrecourse, the debtor could negotiate a reduction of the debt. The forgiveness of all or a portion of a nonrecourse debt without the transfer of the collateral will result in COD income rather than gain from the sale of the property. Alternatively, the debtor could possibly transfer cash equal to the fair value of the collateral instead of transferring the collateral to the lender. In Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the Tax Court appeared to allow results similar to these situations.

However, in a later opinion, 2925 Briarpark, Ltd. V. Commissioner, T.C. Memo 1997-298, aff’d 163 F.3d 313 (5th Cir. 1999), the Fifth Circuit Court of Appeals in affirming the Tax Court decision held against the taxpayer where the lender had agreed to release the property from all liens if the debtor sold the property for a minimum sales price. The court reasoned that the sale of the property and the cancellation of the debt were too closely intertwined to be treated as two separate transactions. Therefore, the debtor was required to recognize gain from the sale of the property rather than COD income.   

These two court cases show that while not easy, it may be possible to accomplish a taxpayer’s desired results through careful planning.