rr-12-14.pdf

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Section 108. - Income from Discharge of Indebtedness

26 CFR 108(a)-1: Income from Discharge of Indebtedness
(Also: Sections 61(a)(12); 704; 752; 1.752-3).

Rev. Rul. 2012-14

ISSUE

How do partners treat the partnership's discharged excess nonrecourse debt in
measuring insolvency under § 108(d)(3) of the Internal Revenue Code?
FACTS

X, an investor other than a partnership, and Holdco, a corporation, are equal
partners in PRS, a partnership for federal tax purposes. In Year 1, PRS borrows
$1,000,000 from Bank and signs a note payable to Bank for $1,000,000 that bears
interest at a fixed market rate payable annually. The note is secured by real estate
valued in excess of $1,000,000 that PRS acquires from Seller, in part with the proceeds
of the note. The note is a nonrecourse liability within the meaning of § 1.752-1(a)(2) of
the Income Tax Regulations. Neither PRS nor its partners (X and Holdco) are
personally liable on the note.

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In Year 2, when the value of the real estate is $800,000 and the outstanding
principal on the note is $1,000,000, Bank agrees to modify the terms of the note by
reducing the note's principal amount to $825,000. At the time that the Bank reduces the
note's principal amount, PRS has no partnership minimum gain with respect to the note
under § 1.704-2(d)(1). The modified note bears adequate stated interest within the
meaning of § 1274(c)(2). The PRS partnership agreement provides for income to be
allocated equally to X and Holdco under § 704(b) and the regulations thereunder. X
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and Holdco share PRS nonrecourse liabilities equally under § 1.752-3. At the time of
the modification of the note, X and Holdco have no assets or liabilities other than their
partnership interests in PRS. PRS's sole asset is the real estate subject to the note,
and PRS's sole liability is the note. The specific exclusion provided by § 108(a)(1)(A)
(bankruptcy exception) does not apply in this case.

LAW

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

Section 108(a)(1)(B) 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 § 108(a)(1)(B) to the
amount by which the taxpayer is insolvent.

Section 108(d)(3) 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

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of the taxpayer's assets and liabilities immediately before the discharge.

Section 108(d)(1) provides that indebtedness of the taxpayer means any
indebtedness for which the taxpayer is liable, or subject to which the taxpayer holds
property. Section 108(d)(6) provides that in the case of cancelled partnership debt, the
insolvency exception of § 108(a)(1)(B) applies at the partner level.

Rev. Rul. 92-53, 1992-2 C.B. 48, provides that the amount by which a
nonrecourse debt exceeds the fair market value of the property securing the debt
(excess nonrecourse debt) is treated as a liability in determining insolvency for
purposes of § 108 to the extent that the excess nonrecourse debt is discharged.
ANALYSIS

In order to properly apply Rev. Rul. 92-53 in a partnership context, the
partnership's discharged excess nonrecourse debt should be associated with the
partner who in the absence of the insolvency or other § 108 exclusion would be required
to pay the tax liability arising from the discharge of that debt. Therefore, a partnership's
discharged excess nonrecourse debt is treated as a liability of the partners for purposes
of measuring the partners' insolvency under § 108(d)(3) based upon how the COD
income with respect to that portion of the debt is allocated among the partners under
§ 704(b) and the regulations thereunder. See Rev. Rul. 99-43, 1999-2 C.B. 506, and
Rev. Rul. 92-97, 1992-2 C.B. 124, regarding the application of § 704(b) to allocations of
COD income.

In this case, Bank cancels $175,000 of PRS's $200,000 excess nonrecourse
debt, generating $175,000 of COD income. PRS's $175,000 COD income is allocated
equally between X and Holdco under § 704(b) and the regulations thereunder. For

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purposes of measuring the insolvency of the partners, PRS's discharged excess
nonrecourse debt is treated as a liability of its partners based upon the COD income
allocation. Thus, X treats $87,500 of PRS's debt as a liability of X, and Holdco treats
$87,500 of PRS's debt as a liability of Holdco. X and Holdco treat their shares of the
cancelled PRS excess nonrecourse debt as their own liabilities in determining whether,
and to what extent, each is insolvent within the meaning of § 108(d)(3).

X and Holdco have no assets or liabilities other than their partnership interests in
PRS. In this case, the value of X's and Holdco's partnership interests in PRS is zero.

Immediately before Bank discharges the indebtedness, X's liability exceeds the
value of X's partnership interest by $87,500, and similarly Holdco's liability exceeds the
value of Holdco's partnership interest by $87,500. Therefore, X and Holdco are each
insolvent to the extent of $87,500 under § 108(d)(3). Accordingly, X and Holdco each
exclude their $87,500 amount of COD income under § 108(a)(1)(B).
HOLDING

For purposes of measuring a partner's insolvency under § 108(d)(3), each
partner treats as a liability an amount of the partnership's discharged excess
nonrecourse debt that is based upon the allocation of COD income to such partner
under § 704(b) and the regulations thereunder.

# EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 92-53 is amplified.

# DRAFTING INFORMATION

The principal authors of this ruling are Kevin I. Babitz and Anne W. Bryson of the
Office of Associate Chief Counsel (Passthroughs & Special Industries). For further

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information regarding this revenue ruling, contact Kevin I. Babitz, Anne W. Bryson, or
Charlotte Chyr at (202) 622-3060 (not a toll-free call).