Commercial Real Estate Partnership Cancellation of Debt Income

What Is CODI?
Borrowed funds usually are not treated as income for tax purposes. If, however, the debt is cancelled or discharged,^[1] the borrowed funds then become taxable income—called cancellation of debt income or CODI. The Supreme Court explained the principle in the seminal case, Kirby Lumber (1931): The discharge of bond debt made available an amount “previously offset by the obligation of bonds now extinct.”^[2] The concept now is codified in the Internal Revenue Code (IRC or “Tax Code”). Income realized from the discharge of indebtedness, such as when debt is cancelled or settled for less than the amount owed to the lender, is included in the borrower’s gross income for tax purposes, unless an exception applies. IRC § 61(a)(11); see also Treas. Reg. § 1.61-12.

As discussed below, some cancelled debt is not gross income for tax purposes because an exception applies. For example, cancelled debt may be excluded from gross income if the debt is discharged in bankruptcy or if the taxpayer is insolvent. IRC § 108(a)(1).

CODI Involving Partnerships
A partnership is generally not a taxable entity for federal income tax purposes. IRC § 701. For these purposes, a “partnership” includes a limited liability company taxed as a partnership. In a partnership, taxable income (and deductions, etc.) are passed through by the partnership to its individual partners, and the individual partners pay tax on their shares of the passed-through taxable income. Similarly, CODI realized by a partnership is allocated to the partners in accordance with their distributive shares. IRC § 702. Distributive shares are determined under the partnership agreement unless its allocation does not have “substantial economic effect,” that is, does not reflect the true economic arrangement among the partners. IRC § 704.

Effect of CODI on Partners
When a partnership realizes CODI, a partner’s basis in the partner’s partnership interest is increased by the partner’s share of that CODI. IRC § 705(a). The basis is essentially the partner’s investment in the partnership for tax purposes. IRC § 722. An increase in basis can be beneficial, as it can reduce taxable gain or increase deductible loss when the partnership interest or partnership assets are sold.

If the partnership debt is cancelled (giving rise to CODI), each partner’s share of the partnership liabilities decreases. This is because the partnership, as a whole, now owes less debt. A decrease in a partner’s share of partnership liabilities is treated as if the partner received a cash distribution from the partnership. IRC § 752(b). This deemed distribution of cash decreases the partner’s basis in the partner’s partnership interest. IRC § 733. A decrease in basis can lead to a higher taxable gain or lower deductible loss when the partnership interest or partnership assets are sold.

If the deemed distribution (the decrease in liabilities allocated to the partner) exceeds the adjusted basis of the partner’s interest in the partnership, the partner must recognize gain. This gain is the amount by which the deemed distribution exceeds the partner’s adjusted basis in the partnership. Essentially, the partner is treated as having received a cash distribution larger than its investment in the partnership, resulting in taxable gain.

In situations where a partnership has CODI, the partners must balance the increase in basis due to the CODI against the decrease in basis due to the deemed distribution from debt cancellation. If the increase in a partner’s basis due to CODI is less than its decrease in basis due to the deemed distribution, the partner might have to recognize a gain. IRC § 731(a).

Attribute Adjustments in the Case of Taxpayer Bankruptcy or Insolvency
A taxpayer’s reliance on the bankruptcy or insolvency (or certain other) exceptions to CODI comes at a cost to the taxpayer: a dollar-for-dollar reduction of the taxpayer’s tax losses, credits and other tax attributes listed below. Those reduced attributes otherwise could have reduced tax in future years. The reduction would be applied to the following attributes, in the following order: (i) net operating losses, (ii) general business credits, (iii) minimum tax credits, (iv) capital loss carryovers, (v) basis, (vi) passive activity loss and credit carryovers, and (vii) foreign tax credit carryovers. IRC § 108(b). Therefore, the exceptions to CODI are generally considered tax deferral and not a complete avoidance of the taxable income. (It should be noted that, under the bankruptcy exception, there can be fact patterns that result in a permanent avoidance of taxable income on cancelled debt.)

The Bankruptcy and Insolvency CODI Exceptions Applied to Partnerships
Tax Code subsection 108(a)(1)(A)-(B) sets forth the bankruptcy and insolvency CODI exceptions, stating:

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if –

(A) the discharge occurs in a title 11 case, [or]
(B) the discharge occurs when the taxpayer is insolvent[.] (emphasis added)

Tax Code subsection 108(d)(1) defines “indebtedness of the taxpayer” for this purpose as:

indebtedness—
(A) for which the taxpayer is liable, or
(B) subject to which the taxpayer holds property.

Tax Code subsection 108(d)(2) defines “title 11 case” for this purpose as:

a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.

Finally, Tax Code subsection 108(d)(6) states:

In the case of a partnership, [subsection 108(a)] shall be applied at the partner level. 

The above appears to mean that only the partners who are themselves the subject debtors in bankruptcy (or insolvent) can benefit from the bankruptcy and insolvency exceptions with respect to their share of the partnership borrower’s discharged debt. If so, any partner who is not itself the subject debtor in bankruptcy (or insolvent) cannot use this exception even if the partnership is the subject debtor in bankruptcy or insolvent.

The above interpretation of the Tax Code requires a partner-level bankruptcy filing in order for a partner to avail itself of the bankruptcy exception. In contrast are four related Tax Court decisions, each arising out of the bankruptcy of In re Notchcliff Associates, Case No. 88-51913 (Bankr. Md. 1988). The four cases (collectively, the so-called “Gracia Cases”) are: Gracia v. Commissioner, T.C. Memo. 2004–147; Mirarchi v. Commissioner, T.C. Memo. 2004–148; Price v. Commissioner, T.C. Memo. 2004–149; and Estate of Martinez v. Commissioner, T.C. Memo. 2004–150. The Notchcliff partnership owned real estate encumbered by more than $20 million in bank debt (supported by partner guarantees). Some portion of the partnership’s bank debt was cancelled through the partnership’s bankruptcy case, apparently giving rise to at least $2.8 million in CODI. Notchcliff’s bankruptcy plan, and contribution agreements it subsequently entered into with certain partners (totaling $250,000), both approved by the bankruptcy court, provided for releases of the partners from all actual or potential claims of creditors (against the partners) arising out of or related to the debtor partnership. That broad release included the partnership bank debt that was canceled. Reasoning that the bankruptcy court exercised jurisdiction over the individual partner taxpayers by granting them a discharge of all partnership-related debts in a title 11 proceeding, the Tax Court in the Gracia Cases held that the Tax Code’s bankruptcy exception to CODI applied to the partners, even though none of the partners themselves were personally in bankruptcy.

Significantly, in four Actions on Decision in 2015, the IRS disagreed with the Tax Court’s holdings in the Gracia Cases. The IRS said:

The Tax Court’s ruling is inconsistent with the structure of section 108 and underlying Congressional intent … The exclusion in section 108(a)(1)(A) applies only to partners who are debtors in bankruptcy in their individual capacities and need a “fresh start.”

Actions on Decision 2015–01 (2015—6 IRB 579) (nonacquiescence in the Gracia Cases), quoting Yamamoto v. Commissioner, 60 T.C.M. 1050, T.C. Memo. 1990-549 (T.C. 1990), aff’d on other grounds, 958 F.2d 380 (9th Cir. 1992). The Tax Court in Yamamoto said (and the Actions on Decision quoted):

The entire structure of section 108, as well as the provision's legislative history (see, e.g., S. Rept. 96-1035, pp. 8-14 (1980), 1980-2 C.B. 620, 623-627), makes it plain that the provision operates to provide tax relief to the debtor in bankruptcy (in the present instance, MFC [a loan company indirectly owned by Mr. Yamamoto]) and not to the debtor of the debtor in bankruptcy (e.g., in the present instance, Yamamoto).

Yamamoto, supra, 60 T.C.M. at 1061. Consistent with (and citing) the Actions on Decision is the regulation issued in 2016 by the IRS on grantor trusts and disregarded entities (e.g. single member LLC’s). Treas. Reg. § 1.108-9. That regulation requires that, for CODI exclusion, the owner of the grantor trust or disregarded entity must be a “debtor” as defined in the Bankruptcy Code: the “person or municipality concerning which a case under this title has been commenced.” 11 U.S.C. § 101(13). In issuing the regulation, the IRS said that, where the partnership holds an interest in a grantor trust or disregarded entity:

[T]he partner to whom the income is allocable must be under the jurisdiction of the court in a title 11 case of that partner as the title 11 debtor to qualify for the bankruptcy exclusion. (emphasis added)

TD 9771, 81 Fed. Reg. 37,504 (June 10, 2016).

Conclusion
Particularly given the potential for a partner having to write a check to the IRS, CODI treatment and implications are important topics, yet the topics are complex, especially when applied to partnerships with debt secured by distressed assets. We will discuss other aspects of CODI in future client alerts.

(This is another in our series of client alerts related to the intersection of bankruptcy and real estate).

^{[1] The words cancelled, discharged, and forgiven, are oftentimes used interchangeably in connection with CODI.}

^{[2] In Kirby Lumber, the taxpayer repurchased, at a discount, bonds it had issued previously. In an opinion written by Associate Justice Oliver Wendell Holmes, Jr., the Supreme Court held that the taxpayer recognized income in the amount of the discount. United States v. Kirby Lumber, 284 U.S. 1 (1931).}