IRS RULES ON EFFECT OF NONRECOURSE DEBT ON INSOLVENCY EXCLUSION TO DISCHARGE OF INDEBTEDNESS INCOME.

Rev. Rul. 92-53

ISSUE

Is the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of section 108(d)(3) of the Internal Revenue Code?

FACTS

SITUATION 1. In 1988, individual A borrowed $1,000,000 from C and signed a note payable to C for $1,000,000 that bore interest at a fixed market rate payable annually. The note was secured by an office building valued in excess of $1,000,000 that A acquired from B with the proceeds of the note. A was not personally liable on the note. 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 $825,000. The modified note bore adequate stated interest within the meaning of section 1274(c)(2) of the Code. At the time of the modification, A's only other assets had an aggregate fair market value of $100,000, and A was personally liable to D on other indebtedness in the amount of $50,000.

SITUATION 2. The facts are the same as SITUATION 1, except that D agreed to accept assets from A with a fair market value (and basis to A) of $40,000 in settlement of A's recourse indebtedness of $50,000, and C did not reduce A's nonrecourse note.

SITUATION 3. The facts are the same as SITUATION 1, except that pursuant to a prearranged work-out plan D agreed to accept assets from A with a fair market value (and basis to A) of $40,000 in settlement of A's recourse indebtedness of $50,000, and shortly thereafter C reduced the principal amount of A's nonrecourse note to $825,000.

These examples do not involve the bankruptcy or qualified farm indebtedness of the taxpayer. Thus, the specific exclusions provided by sections 108(a)(1)(A) and 108(a)(1)(C) 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(a)(1)(B) of the Code generally excludes discharged indebtedness from a taxpayer's gross income if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) limits the amount of income excluded by reason of section 108(a)(1)(B) to the amount by which the taxpayer is insolvent.

Section 108(d)(3) of the Code defines "insolvent" as the excess of liabilities over the fair market value of assets. That section further provides that whether a taxpayer is insolvent, and the amount by which the taxpayer is insolvent, is determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.

Section 108 of the Code does not define the term "liabilities" as used in the section 108(d)(3) definition of insolvency. However, the legislative history underlying the section 108 insolvency exclusion provides, as a rationale for the insolvency exclusion, that an insolvent taxpayer should not be burdened with current taxation on the discharge of indebtedness to preserve the taxpayer's "fresh start" resulting from that discharge. H.R. Rep. No. 833, 96th Cong., 2d Sess. 7, 9 (1980); S. Rep. No. 1035, 96th Cong., 2d Sess. 8, 10 (1980), 1980-2 C.B. 620, 624. That is, discharging a taxpayer from liability gives the taxpayer a fresh start that should not be impeded by imposing a tax liability on the taxpayer when the taxpayer is unable to pay either the indebtedness or the tax. But, to the extent a discharge of indebtedness removes a taxpayer from insolvency, the taxpayer is treated as having the ability to pay tax, and thus must pay a current tax on that portion of the discharge. See section 108(a)(1)(B) and (a)(3).

To provide tax relief that will preserve a fresh start, the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt ("excess nonrecourse debt") should be treated as a liability in determining insolvency for purposes of section 108 of the Code to the extent that the excess nonrecourse debt is discharged. Otherwise, the discharge could give rise to a current tax when the taxpayer lacks the ability to pay that tax. Nonrecourse debt should also be treated as a liability in determining insolvency under section 108 to the extent of the fair market value of the property securing the debt.

However, excess nonrecourse debt that is not discharged does not have a similar effect on a taxpayer's ability to pay a current tax resulting from the discharge of another debt (whether recourse or nonrecourse). Thus, that excess nonrecourse debt should not be treated as a liability in determining insolvency for purposes of section 108 of the Code.

SITUATION 1. In this situation, $175,000 of A's $200,000 excess nonrecourse debt is discharged and, therefore, that portion of the excess nonrecourse debt is taken into account in determining whether, and to what extent, A is insolvent within the meaning of section 108(d)(3) of the Code. Thus, A has liabilities of $1,025,000, consisting of the full $50,000 amount for which A is personally liable, plus the portion of the nonrecourse debt equal to the sum of the $800,000 fair market value of the property securing the nonrecourse debt and the $175,000 of excess nonrecourse debt that is discharged. Because A's $1,025,000 of liabilities exceed the $900,000 fair market value of A's assets ($800,000 + $100,000) by $125,000 immediately before the indebtedness is discharged, A is insolvent to the extent of $125,000. Accordingly, pursuant to section 108(a)(1)(B) and (a)(3), A must include only $50,000 of the $175,000 of discharged indebtedness ($175,000 - $125,000) in income under section 61(a)(12).

SITUATION 2. In this situation no portion of the excess nonrecourse debt is discharged. Instead, $10,000 of A's recourse debt is discharged. Therefore, the excess nonrecourse debt is not taken into account in determining whether, and to what extent, A is insolvent within the meaning of section 108(d)(3) of the Code. As a result, A is solvent immediately before the discharge because its $850,000 of liabilities ($800,000 + $50,000) do not exceed the $900,000 fair market value of its assets ($800,000 + $100,000). Accordingly, A must include the entire $10,000 of discharged indebtedness in income under section 61(a)(12).

SITUATION 3. In this situation, pursuant to the prearranged work-out plan, $10,000 of A's recourse debt is discharged, and shortly thereafter $175,000 of A's nonrecourse debt is discharged. Because of the prearranged plan, the discharges are viewed as occurring simultaneously, but solely for purposes of determining whether, and to what extent, A is insolvent within the meaning of section 108(d)(3) of the Code. As a result, A must include only $60,000 of the total of $185,000 of discharged indebtedness in income under section 61(a)(12). The $60,000 is comprised of (1) the $50,000 discharge of indebtedness income as determined with respect to the nonrecourse debt in SITUATION 1, and (2) the $10,000 discharge of indebtedness income as determined with respect to the recourse debt in SITUATION 2.

HOLDING

The amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of section 108(d)(3) of the Code, but only to the extent that the excess nonrecourse debt is discharged.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 91-31, 1991-1 C.B. 19, is distinguished from this revenue ruling. Rev. Rul. 91-31 holds that the reduction of the principal amount of an undersecured nonrecourse indebtedness (by the holder of a debt who was not the seller of the property securing the debt) results in discharge of indebtedness income under section 61(a)(12) of the Code. However, Rev. Rul. 91-31 does not address the treatment of nonrecourse indebtedness in applying the section 108 insolvency exclusion.

DRAFTING INFORMATION

The principal author of this revenue ruling is John P. Moriarty of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mark A. Schneider of the Office of Assistant Chief Counsel (Income Tax and Accounting) on (202) 566-3802 (not a toll-free call).