Rev. Rul. 82-202

ISSUE

Does a taxpayer realize income when the taxpayer prepays the mortgage on the taxpayer's residence at less than the principal balance, under the circumstances described below?

FACTS

In order to reduce the number of its low-interest mortgages, a financial institution offered a 10-percent discount to each individual with an existing low-interest mortgage on a personal residence who would prepay the balance. The taxpayer who had borrowed money from the financial institution in order to purchase a residence from a third party paid the financial institution 18x dollars in full payment of the taxpayer's note and mortgage when the mortgage balance was 20x dollars. The fair market value of the residence was greater than the principal balance at the time of the transaction, and the taxpayer was financially solvent both before and after the mortgage prepayment. The taxpayer was not personally liable to the financial institution on the mortgage indebtedness.

LAW AND ANALYSIS

Under section 61(a)(12) of the Internal Revenue Code, gross income includes income from the discharge of indebtedness, except as otherwise provided by law.

Section 1.61-12 of the Income Tax Regulations provides that a taxpayer may realize income by the payment or purchase of the taxpayer's obligations at less than their face value.

Section 108(a)(1) of the Code excludes from a taxpayer's gross income any amount realized from the discharge of indebtedness, but only if (A) the discharge occurs in a title 11 case, (B) the discharge occurs when the taxpayer is insolvent, or (C) the indebtedness discharged is qualified business indebtedness.

In United States v. Kirby Lumber Co., 284 U.S. 1 (1931), X-2 C.B. 356 (1931), which involved a corporation that purchased its own bonds at less than their issue price, the Supreme Court of the United States held that a taxpayer-debtor realizes ordinary income upon the payment or purchase of its obligation in an arm's length transaction at less than its face amount.

The cancellation or reduction of a liability incurred on the purchase of property is subject to the same rules as cancellation of other debts and is considered to produce taxable income under section 1.61-12(a) of the regulations and Kirby Lumber unless the transaction is specifically excepted.

The facts here do not involve the bankruptcy, insolvency, or a qualified business indebtedness of the taxpayer. Thus, the specific exclusions provided by section 108(a) do not apply.

HOLDING

The taxpayer realizes 2x dollars of ordinary income upon the prepayment of the principal balance on the mortgage.

The taxpayer would also realize ordinary income if (1) a discount was received for the prepayment of only a portion of the outstanding balance rather than the entire balance, or (2) the taxpayer was personally liable to the financial institution on the mortgage indebtedness.