The Rumor: The American Recovery and Reinvestment Act of 2009 (the Recovery Act) allows taxpayers to defer all debt forgiveness income (COD) for four or five years and then the taxpayer has an additional five-year period over which the income is taxed.

The Truth: The Recovery Act provides COD deferral for a few specified transactions. One transaction not covered by the statutory change is a straight foreclosure of property triggering debt forgiveness by the lender.

Background: COD occurs when a lender forgives a taxpayer’s debt.1 The US Internal Revenue Code (the Code) characterizes COD as ordinary income and excludes it from a taxpayer’s gross income in certain circumstances. COD generally arises from a transaction in which a taxpayer is relieved of an obligation to repay recourse debt. COD does not arise when the taxpayer exchanges property in satisfaction of a debt.2 In that case, the taxpayer has gain or loss to the extent that the amount realized on the exchange of the property (including the debt securing the property) exceeds (or is less than) the taxpayer’s adjusted basis in the property. If the debt is recourse, the property is considered to be sold for an amount of debt equal to the property’s fair market value and the forgiven balance of the debt gives rise to COD. If the debt is non-recourse, the property is considered sold for the amount thereof. Whether the gain or loss is capital or ordinary depends on the nature of the property disposed of. It is unclear whether debt that is generally recourse to all the assets of a special purpose limited liability entity that holds only a single asset is recourse or nonrecourse for tax purposes.

Current COD exclusions include: COD generated by the discharge of debt occurring in a Title 11 bankruptcy case; COD occurring when a taxpayer is insolvent; COD arising from indebtedness meeting the definition of “qualified farm indebtedness;” and, for non-C corporation taxpayers, COD arising from indebtedness meeting the definition of “qualified real property indebtedness.” When a taxpayer excludes COD from its income under one the above exceptions, it generally has to reduce certain tax attributes by the amount of the excluded COD. Thus, the COD exclusion effectively defers the income recognition to a later date. In the situation where a partnership is the debtor, the Code provides that the COD exclusions are applied at the partner level.

Section 1231 of the Recovery Act added new Section 108(i) to the Code. Under Section 108(i), a taxpayer realizing COD in connection with the “reacquisition” of “an applicable debt instrument” after December 31, 2008, and before January 1, 2011, may elect to recognize that income ratably over the five-taxable-year period beginning with the fifth taxable year following the reacquisition year in the case of a reacquisition occurring in 2009, and the fourth taxable year following the reacquisition year in the case of a reacquisition occurring in 2010. If the taxpayer elects to apply Section 108(i), it may not also apply any of the other COD exclusions.

Although Section 108(i) defines an “applicable debt instrument” in a relatively normal fashion, provided the debt was incurred by a C corporation or in connection with debtor’s trade or business, it defines “reacquisition” in a limited fashion. In particular, a debtor “reacquires” debt for Section 108(i) purposes only if it discharges it for cash, for another debt instrument, for corporate stock or a partnership interest, or as a contribution to capital. The term “reacquisition” also includes the complete forgiveness of the indebtedness by the creditor. Section 108(i) ends the deferral upon certain circumstances, including death, the cessation of business, liquidation, or sale of substantially all of the taxpayer’s assets. Finally, the statute provides the Secretary of the Treasury with the authority to “prescribe such regulations, rules, or other guidance as may be necessary or appropriate for purposes of applying [Section 108(i)].”

In sum, even though it is an economically similar transaction, it appears that a taxpayer may not claim Section 108(i) deferral where the taxpayer incurs COD due to a lender’s foreclosure on the taxpayer’s property because it is not one of the five enumerated transactions. However, the Conference Report contains language indicating that the five enumerated transactions may not be all of the transactions included in the term "acquisition." Therefore, we hope that the Treasury uses its regulatory authority to specifically allow taxpayers to use Section 108(i) deferral of COD from a foreclosure.

Issues to Consider:

1) What is a complete forgiveness of the debt for Section 108(i) purposes?

A taxpayer could argue that after a foreclosure the remaining debt was completely forgiven, so this rule should apply. However, reading the language in that context would effectively read out of the statute the four enumerated transactions that trigger application of this section, because after all of those transactions there is a complete forgiveness of the debt above the exchanged value. In addition, we have been informed that representatives of the real estate industry tried and failed to get the statutory language amended to read that a reacquisition can occur for cash or other property. Based on these arguments, it does not appear that a taxpayer can use the completely forgiven provision to defer COD on a property foreclosure. Similarly, it appears that a partial debt forgiveness that does not arise to the level of an exchange of a new debt instrument for an existing debt instrument falls outside of Section 108(i).

2. Does the foreclosure trigger COD that may be excludible under Section 108 (including 108(i)) or sale or exchange income that is not excludible?

Modern real estate ventures generally hold property in special purpose entities (SPE). These SPEs are limited liability entities that hold only a single property. The SPE obtains financing to purchase/develop the property. By its terms, the SPE secures this loan with all of the SPE’s assets. Therefore, under local law, the loan is generally recourse because, by its terms, its security is not limited to a single asset. As a factual matter, however, the loan is nonrecourse because the SPE only has a single property that secures it. Thus, there is no clear answer as to whether this type of arrangement creates recourse or nonrecourse indebtedness for tax purposes and, correspondingly, whether a foreclosure triggers COD or sale or exchange gain or loss.

3. Can the taxpayer structure a transaction to take advantage of this rule?

Knowing that a straight foreclosure of the property falls outside of Section 108(i), a taxpayer may be able to structure a transaction that meets the requirements of the provision. However, such a transaction must have economic substance to be respected. For example, a taxpayer that sold property to a third party and used the proceeds to repay the lender in satisfaction of the entire debt was treated as though the lender foreclosed on the property because the lender conditioned the discharge on the sale to the third party and ensured that it would receive all of the proceeds.3

4. Mismatch of this election with the other COD rules with respect to partnerships.

With respect to partnerships, the individual partners determine whether they can exclude COD income. This allows each partner to treat COD income passed through from the partnership differently. Section 108(i) provides that the partnership makes the election to defer recognizing COD. If a partnership makes a Section 108(i) election, none of the other COD exclusions may be applied. Thus, if all of the partners do not share the same tax attributes, they may have different views as to whether the Section 108(i) election should be made. For example, Partner A may be insolvent while Partner B may not. Partner B would prefer that the partnership make the Section 108(i) election to defer the partnership's COD while Partner A would prefer that the partnership not make the election so that it can make the election to use the insolvency exception. In these circumstances, it is important to understand which partner has the power to make the election and the circumstances surrounding its exercise.

5. Mismatching of partnership income recognition and Section 752 basis adjustments.

A partnership’s partners adjust their tax bases in their partnership interests by the amount of the partnership’s debt. When a partnership borrows money, the partners’ bases increase. When the debt is repaid or forgiven, the partners’ bases decrease. Section 108(i) provides that the partners do not immediately decrease their bases by the full amount of the forgiven debt if the partnership makes the election to defer the COD. If the partners did have to reduce their bases, then they may not receive deferral due to the interaction of the Sections 752 and 731. However, Section 108(i) does not provide for a matching of basis reduction and income inclusion. Instead, Section 108(i) provides that a partner does not decrease the partner’s basis “to the extent it would cause the partner to recognize gain under section 731.” This means that the partners must reduce their basis by the forgiven debt until their bases equal zero and also means that there may be some unexpected timing issues due to the mismatch between the basis reduction and the income inclusion.

If you have any questions about this Alert or the application of the COD income deferral provision of the 2009 Recovery Act to real estate foreclosures, please do not hesitate to contact any of the Arent Fox attorneys below:

Robert Honigman
honigman.robert@arentfox.com
202.857.6041  

Joseph Rieser
rieser.joseph@arentfox.com
202.857.8964

Robert Falb
falb.robert@arentfox.com
202.715.8569

Kenneth Yoon
yoon.kenneth@arentfox.com
212.484.3981

Elizabeth Mullen
mullen.elizabeth@arentfox.com
202.775.5704

Melanie Bartlett
bartlett.melanie@arentfox.com
202.715.8571 

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1 Section 61(a)(12)

2 Section 61(a)(3)

3 2925 Briarpark Ltd. v. Comm’r, 163 F.3d 313 (5th Cir. 1999).