Tax Court rules cancellation of debt is part of gain realization

Editor: Alexander J. Brosseau, CPA

On Aug. 10, 2023, the Tax Court held in Parker, T.C. Memo. 2023-104, that an S corporation’s debt that was canceled in connection with the transfer of property should be included in the amount realized on the transfer of property and not as cancellation-of-debt (COD) income.

Facts

In Parker, the petitioner, Michael Parker, owned 100% of the stock of Exterra Realty Partners LLC, an S corporation. Exterra owned 100% of the membership interests in two limited liability companies (LLCs), PLF-XIII and PLF-XIV. PLF-XIII in turn owned 100% of the membership of Montevina Phase I LLC (Montevina 1), and PLFXIV owned 100% of the membership interest of Montevina Phase II LLC (Montevina 2). PLF-XIII, PLF-XIV, Montevina 1, and Montevina 2 were all treated as disregarded entities for federal income tax purposes. In addition, separate from the Exterra structure, Parker was individually the sole member of PLF-XI (an LLC treated as a disregarded entity), which in turn was the member of another LLC that owned real property in Iowa (the Iowa property).

In 2007, the five disregarded entities held borrowed money from a lender in order for the Montevina entities to purchase real property in Livermore, Calif., (the Livermore property) for the purpose of commercial development. Two of the loans were senior mortgages on the Livermore property, one that named Montevina 1 as the borrower and another that named Montevina 2 as the borrower (the senior mortgages). The senior mortgages were described as nonrecourse loans for which the only recovery of the lender was in Montevina 1’s and Montevina 2’s ownership in the Livermore property (which included improvements to the real property as it was developed).

Two of the loans were mezzanine loans issued to PLF-XIII and PLF-XIV for which PLF-XIII and PLF-XIV each pledged their interests in the Montevina entities. The fifth loan was issued to PLF-XI, with the funds being contributed to the Montevina entities (the opinion is not clear as to how these contributions were made, as PLF-XI did not own any interest in the Montevina entities). Finally, Parker signed personal guarantees for all five loans.

In 2012 the parties described above engaged in a transaction and a number of contractual agreements with the lender and certain unrelated third parties (buyers) for the buyers to purchase the Montevina entities and assume some, but not all, of the loans. Pursuant to the agreements, the buyers purchased 100% of the membership interest of Montevina 1 and Montevina 2 for a nominal amount of cash and assumed the liabilities of the senior mortgages, with the buyers signing new personal guarantees for the senior mortgages. Also pursuant to the agreements, Parker transferred the Iowa property to an escrow to be disbursed to the lender, and the lender would cancel all remaining obligations (the two mezzanine loans and the PLF-XI loan) and release Parker from his personal guarantees.

The case was submitted to the Tax Court pursuant to Rule 122, stipulating the facts and with the sole issue for decision whether the income from the cancellation of the debt should be included in the amount realized on the sale of real property under Regs. Sec. 1.1001-2 or whether the amount should be treated as COD income.

Cancellation of nonrecourse debt: Tufts

Generally, when a lender cancels recourse debt in exchange for property that has a fair market value (FMV) less than the adjusted issue price of the debt canceled, the consequences are bifurcated. First, the debtor will recognize Sec. 1001 gain to the extent that the property’s FMV exceeds the debt’s basis. Second, the debtor will recognize COD income under Sec. 61(a)(12) in an amount equal to any excess of the adjusted issue price of the debt canceled over the property’s FMV (see, e.g., Regs. Sec. 1.1001-2(c), Example (8), and Rev. Rul. 90-16).

The consequences for the cancellation of nonrecourse debt, however, do not always result in COD income. Generally, if nonrecourse debt is canceled in exchange for the property that is subject to the debt, then the debtor will instead treat the face amount of the debt as the amount realized in a Sec. 1001 transaction and thus will have Sec. 1001 gain to the extent the face amount of the debt exceeds the basis of the property transferred (Tufts gain), unless another provision of the Code, such as Sec. 368, prevents the recognition of the Sec. 1001 gain (see Tufts, 461 U.S. 300 (1983)).

Therefore, Sec. 61(a)(12) (regarding COD income) and Sec. 108(a) (regarding exclusion of COD income) do not apply where there is a cancellation of nonrecourse debt in exchange for the property subject to that debt. This disparate treatment between recourse debt and nonrecourse debt upon a cancellation in connection with the transfer of the collateral makes the determination as to whether debt is recourse or nonrecourse instrumental in any foreclosure proceeding, bankruptcy, or out-of-court debt workout.

Determining whether debt is recourse or nonrecourse with disregarded entities

It is important to note that the determination of whether debt is recourse or nonrecourse is important for many sections of the Code. Some have similar purposes and may be analyzed in a similar fashion, but the determination that a loan is recourse or nonrecourse for one purpose of the Code does not necessarily mean it will be treated as recourse or nonrecourse for other purposes.

For purposes of Regs. Sec. 1.1001-2, “indebtedness is generally characterized as ‘nonrecourse’ if the creditor’s remedies are limited to particular collateral for the debt and as ‘recourse’ if the creditor’s remedies extend to all the debtor’s assets” (Great Plains Gasification Assocs., T.C. Memo. 2006-276). While this definition is clear in most circumstances, when a loan’s debtor is a disregarded entity, determining whether the loan should be treated as recourse or nonrecourse can be much more difficult.

The IRS has issued guidance holding that loans that are recourse to a disregarded entity can be considered nonrecourse to the borrower’s regarded tax owner, but the Service has been inconsistent in determining when a loan to a disregarded entity should be treated as recourse. In certain guidance, the IRS appears to treat debt owed by a disregarded entity that is not guaranteed by its regarded owner as essentially per se nonrecourse.

Most recently, in Letter Ruling 202050014, the IRS ruled in 2020 that debt of a disregarded LLC was nonrecourse to the regarded owner of that LLC, even though the taxpayer owned no material assets other than the interest in the LLC. In addition, in both Letter Ruling 201644018 issued in 2016 and Chief Counsel Advice memorandum (CCA) 20150301F, the IRS also held that debt owed by a disregarded entity was treated as nonrecourse to the regarded owner. While the CCA and the 2016 letter ruling are redacted and not all information is available, both ruled that debt of a disregarded entity was nonrecourse, although they only briefly addressed the issue and ruled as they did due simply to the fact that the disregarded entity was personally liable on the debt while the sole regarded member was not.

In contrast to these, in CCA 201525010, the IRS seems to contemplate an approach based on facts and circumstances in determining whether debt was recourse or nonrecourse for purposes of Regs. Sec. 1.1001-2. In CCA 201525010 the IRS was addressing whether a loan owed by a special-purpose entity should be treated as recourse or nonrecourse for purposes of Regs. Sec. 1.1001-2.

The CCA’s facts describe the taxpayer as an LLC treated as a partnership that was a special-purpose entity organized solely to hold real property and then construct, market, and sell homes that it might build on the real property. As discussed in the CCA, the loan agreement did not provide any language imposing personal liability for repayment on the LLC, but the notes were secured by guarantees from all LLC members.

In a nonjudicial foreclosure, the LLC relinquished all of its property to its lender, and the lender canceled all remaining debt. While the CCA did not conclude whether the loan should be considered recourse or nonrecourse, it stated the facts that should be considered and analyzed when determining whether the loan should be considered recourse or nonrecourse, and that express unconditional personal liability of the direct taxpayer may not be necessary to make debt recourse to the entity. The CCA recommends that “[t]he combination of Members’ pledges, general assignment of rights, and guarantees, in addition to the loan being secured by all assets of the Taxpayer as a result of its status as a [special-purpose entity], may be sufficient for the loan to be recourse to the entity.”

As discussed by commentators, the facts-and-circumstances approach may be more appropriate where, as in this instance, having the LLC itself guarantee the loan would have simply been a formality, since the lender could have secured all assets by virtue of the owner guarantees (see Garlock et al., Federal Taxation of Debt Instruments, Chapter 105.01 (Wolters Kluwer 2021)). While the guidance above appears to indicate the IRS is likely to consider debt owed by a disregarded entity as nonrecourse to its regarded owner, the debt should still be evaluated based on facts and circumstances to confirm that debt that is nonrecourse in form is not effectively recourse.

In Parker, the parties stipulated to the fact that the loans were nonrecourse; however, it is unclear whether the parties meant for this stipulated fact to also control as the legal conclusion that the loans were nonrecourse for purposes of Regs. Sec. 1.1001-2, and the parties did not appear to litigate the issue of whether the loans should be considered recourse. Although the issue was not litigated, the facts in Parker appear similar to those of CCA 201525010 (with a few significant differences). Exterra was set up as a real estate development entity with the purpose to purchase the Livermore property and develop office buildings on the property for sale. Although the Tax Court opinion does not discuss whether Exterra owned any property other than the disregarded entities discussed above, the record indicates that Exterra was left with a nominal amount of assets and liabilities after the transaction described above.

Although the issue may not have been fully litigated by the parties, the Tax Court briefly discussed the recourse nature of the loans. In addressing an argument Parker made, the court indicated that the determination of whether the loans were recourse should be made with respect to Exterra and not to Parker. The Tax Court said, “Accordingly, petitioners’ observation, for instance, that [the mezzanine loans] were recourse as to Mr. Parker personally, is simply irrelevant to the issue before us.” The Tax Court then stated that the parties had stipulated that the loans were nonrecourse to Exterra and concluded that the cancellation of the mezzanine loans should be treated as an amount realized under Regs. Sec. 1.1001-2 and not as COD income.

Similar to most of the IRS guidance, the Tax Court treated the debt owed by the disregarded entities as nonrecourse as to the regarded tax entity, without significant discussion of factors such as the ones mentioned in CCA 201525010. Since the parties in Parker stipulated to the fact that the loans were nonrecourse to Exterra and did not litigate whether the loans were recourse for purposes of Regs. Sec. 1.1001-2, not much can be taken from the case’s opinion. However, even though the court was clearly correct in stating that the issue was whether the loan was recourse to Exterra (and not Parker), the fact that there was a guarantee by the sole owner might still be a factor to consider in determining whether the loan was effectively recourse to Exterra.

Debt treated as a modification in a separate transaction pursuant to Regs. Sec. 1.1274-5

One issue the Tax Court did not address was whether a modification of the debt should be treated as occurring in a separate transaction from the transfer of the property to the buyers under Regs. Sec. 1.1274-5, which would require treating the income as COD income. Regs. Sec. 1.1274-5(b) (1) provides that where debt is assumed or property is taken subject to a debt instrument in connection with a sale or exchange of property, and the debt instrument is modified such that the modification triggers an exchange under Sec. 1001, the modification is treated as a separate transaction taking place immediately before the sale or exchange and is attributed to the seller of the property.

The IRS has not issued significant guidance regarding this regulation and how it interacts with treatment of gain associated with the cancellation of debt and the transfer of property; however, the IRS has indicated that Regs. Sec. 1.1274-5(b) would require treating the modification as separate from the disposition. In a Field Service Advice memorandum dated Sept. 29, 1995 (available at 1995 FSA Lexis 437), in dealing with an issue that did not directly implicate Regs. Sec. 1.1274-5, the IRS stated that “an assumption of an existing debt by a buyer in conjunction with a reduction of indebtedness by the lender, would be subject to section 1.1274-5(b), which treats the modification of the debt separately from the disposition of the property.”

Generally, under this regulation, if a taxpayer transfers property subject to debt to a third party, and, in connection with that transaction, the lender agrees to decrease the loans’ principal balance, the transaction will be treated as separate transactions: first, a debt modification under Regs. Sec. 1.1001-3 (for which the seller/debtor may recognize COD income), and, second, a transfer of property to the new lender subject to the newly modified loan. Note that, even if the modification occurs after the transaction, Regs. Sec. 1.1274-5(b) may still treat that modification as occurring in a separate transaction that occurs immediately prior to the transfer of the property.

In Parker, no party raised the issue of whether Regs. Sec. 1.1274-5(b) applied, and it was not discussed by the Tax Court. The transaction in Parker did involve the sale of property subject to debt to a third party, and, thus, to the extent a debt is significantly modified, Regs. Sec. 1.1274-5 may apply to such a transaction to treat the reduction in the debt as occurring in a separate transaction from the transfer of property, resulting in COD income.

Planning debt arrangements is key

Parker left unaddressed a couple of potential issues that are not often dealt with by the court and the IRS and still present much uncertainty for taxpayers. While not much can be taken from the Tax Court’s opinion in Parker, as the facts were fully stipulated and some of the potential issues were not fully litigated, the case still serves as a reminder of the importance of carefully planning all debt arrangements to align all desired economic and tax consequences that stem from the debt.

Editor Notes

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. For additional information about these items, contact Brosseau at abrosseau@deloitte.com. Unless otherwise noted, contributors are associated with Deloitte Tax LLP.

This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.