REDUCTION OF DEBT BY THIRD-PARTY LENDER IS NOT PURCHASE PRICE ADJUSTMENT.

Rev. Rul. 92-99

ISSUE

If the principal amount of an undersecured nonrecourse debt that arose out of the purchase of property is reduced by the holder of the debt who was not the seller of the property, does the debt reduction result in discharge of indebtedness income under section 61(a)(12) of the Internal Revenue Code, or is the debt reduction treated as a purchase price adjustment that reduces the basis of the property securing the debt?

FACTS

In 1988, individual A purchased an office building from B for $1,000,000, its fair market value. To pay for the building, A signed a note payable to C, a third-party lender, for $1,000,000. The note bore interest at a fixed market rate payable annually and was secured by the office building. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note's principal amount to $800,000. C's reduction in the note was not based on an infirmity that clearly related back to B's original sale (e.g., B's inducement of a higher purchase price by a misrepresentation of a material fact or by fraud). The modified note bore adequate stated interest within the meaning of section 1274(c)(2) of the Code.

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

LAW AND ANALYSIS

Section 61(a)(12) of the Code provides that gross income includes income from the discharge of indebtedness. Section 1.61- 12(a) of the Income Tax Regulations provides that the discharge of indebtedness, in whole or in part, may result in the realization of income.

Section 108(e)(5) of the Code permits a debt reduction to be treated as a purchase price adjustment under certain circumstances. Section 108(e)(5) provides that if (A) the debt of a purchaser of property to the seller arising out of the purchase is reduced, (B) the debt reduction does not occur in a title 11 bankruptcy case or when the purchaser is insolvent, and (C) the reduction would be treated as income to the purchaser from the discharge of indebtedness but for paragraph (e)(5), then such reduction will be treated as a purchase price adjustment. This purchase price adjustment treatment will result in a reduction in the basis of the property securing the debt rather than discharge of indebtedness income.

The debt in this case was reduced by an agreement between C (the third-party lender) and A (the purchaser) of the property. Even though the debt arose in connection with the purchase of the property by A from B, it was not a debt of the purchaser (A) "to the seller" (B), as required by section 108(e)(5)(A) of the Code. Thus, the debt reduction by C does not qualify as a purchase price adjustment under section 308(e)(5) of the Code.

In addition, the debt reduction by C is not considered a purchase price adjustment under common law. See Fifth Avenue- Fourteenth Street Corp. v. Commissioner, 147 F.2d 453, 456-57 (2d Cir. 1945), in which the court stated that a purchase price adjustment is limited to a case where the seller-mortgagee agreed to the debt reduction. The Service generally will not follow cases permitting a purchase price adjustment by third-party lenders, such as Hirsch v. Commissioner, 115 F.2d 656 (7th Cir. 1940), and Allen v. Courts, 127 F.2d 127 (5th Cir. 1942). An agreement to reduce a debt between a purchaser and a third-party lender is not a true adjustment of the purchase price paid for the property because the seller has received the entire purchase price from the purchaser and is not a party to the debt reduction agreement. The debt reduction relates solely to the debt and results in discharge of indebtedness income to the debtor.

Hirsch and Allen relied on Bowers v. Kerbaugh-Empire Company, 271 U.S. 170 (1926), to conclude that no discharge of indebtedness income resulted from a reduction of third-party debt. These cases reasoned that the proceeds of third-party debt should be traced to the investment for which the proceeds were used, and any loss (realized or unrealized) on that investment may be used to offset any income from the discharge of the debt.

However, subsequent Supreme Court decisions and other court cases, when viewed together, have discredited Kerbaugh-Empire. See Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931), which established the annual accounting period concept; United States v. Kirby Lumber Co., 284 U.S. 1 (1931), which held that the discharge of an indebtedness resulted in gross income; Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), which held that gross income included all accessions to wealth from whatever source; Commissioner v. Tufts, 461 U.S. 300 (1983), which held that the amount realized on the sale of property encumbered by a nonrecourse obligation (that exceeded the fair market value of the property) included the amount of the obligation discharged; and Vukasovich v. Commissioner, 790 F.2d 1409 (9th Cir. 1986), which held that the discharge of an indebtedness resulted in gross income, notwithstanding the loss that the taxpayer incurred on the underlying transaction. Citing the above Supreme Court cases, the Ninth Circuit in Vukasovich stated that Kerbaugh- Empire was inconsistent with those decisions, and concluded that when an accession to wealth resulting from the discharge of indebtedness was otherwise includible in gross income, Kerbaugh-Empire did not prevent the taxation of that income.

Further, the Service will not follow Commissioner v. Sherman, 135 F.2d 68 (6th Cir. 1943), involving a third-party lender, to the extent that it relied on Kerbaugh-Empire to permit a purchase price adjustment. The Service will, however, treat a debt reduction in third-party lender cases as a purchase price adjustment to the extent that the debt reduction by the third-party lender is based on an infirmity that clearly relates back to the original sale (e.g., the seller's inducement of a higher purchase price by misrepresentation of a material fact or by fraud). Cf. Commissioner v. Sherman, 135 F.2d at 70. No other debt reduction by a third-party lender will be treated as a purchase price adjustment.

The reduction in the note by the third-party lender (C) in this case was not based on an infirmity that clearly relates back to the original sale, so A cannot treat C's debt reduction as a purchase price adjustment. Thus, A realizes $200,000 of discharge of indebtedness income in 1989 under section 61(a)(12) of the Code.

HOLDING

If the principal amount of an undersecured nonrecourse debt that arose out of the purchase of property is reduced by the holder of the debt who was not the seller of the property, this debt reduction may not be treated as a purchase price adjustment (in the absence of an infirmity that clearly relates back to the original sale), but results in discharge of indebtedness income under section 61(a)(12).

DRAFTING INFORMATION

The principal author of this revenue ruling is Sharon L. Hall of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Ms. Hall on (202) 622-4930 (not a toll-free call).