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:: Partnership - Audit Technique Guide - Chapter 8 - Real Estate Issues in Partnerships (12-2002)   Chapter 8 - Table of Contents Introduction   Issue:  Cancellation of Indebtedness ─ IRC sections 108 and 1017   Non-Recourse Debt        Recourse Debt         Exceptions         Examination Techniques       Supporting Law        Resources     Issue:  Disposition of Property Subject to Non-Recourse Debt and Unpaid Interest         Examination Techniques       Supporting Law        Resources     Issue:  Accrued Contingent Interest       Examination Techniques       Supporting Law        Resources      Issue:  Bankruptcy      Bankruptcy Basics        Partnership Bankruptcy       Partners Bankruptcy        Examination Techniques       Supporting Law        Resources        Issue:  Low Income Housing Tax Credit (IRC section 42)    Examination Techniques       Supporting Law        Resources        Issue:  Capturing “Phantom” Gain In Zombie Partnerships    How to Recognize a Zombie       Examination Techniques       Supporting Law       Issue:  IRC section 263A ─ Uniform Capitalization     Examination Techniques       Supporting Law        Resources    back to the top INTRODUCTION Approximately 50 percent of all partnerships are involved in the real estate business.  A partnership may be involved in real estate development, construction, or leasing.  Even though a partnership may not be involved in a real estate business it may own or lease real estate.  This chapter covers various tax issues related to real estate such as: Cancellation of Indebtedness Tufts/ Non-recourse Debt and Unpaid Interest Accrued Contingent Interest Bankruptcy Low Income Housing Tax Credit Zombie Partnerships Uniform Capitalization ─ IRC section 263A The first two issues deal with the determination of whether the reduction of partnership debt should be treated as taxable cancellation of indebtedness income under IRC section 61(a)(12).  Cancellation of indebtedness income may not be taxable due to an exception under IRC section 108, or it may be considered a taxable gain from the sale/exchange of property under IRC section 61(a)(3).  See decision chart (Exhibit 8-1) at the end of this chapter as an audit aid to assist you in making this determination. back to the top ISSUE:  CANCELLATION OF INDEBTEDNESS ─ IRC SECTIONS 108 AND 1017 When a partnership purchases real estate it normally finances a portion of the purchase price.  Partnerships may refinance or restructure the debt due to financial difficulties, to get a lower interest rate, or borrow more money.  If the partnership refinances or restructures the debt and part or all of the debt is discharged, the partnership will realize cancellation of indebtedness (COD) income.  If a financially troubled partnership’s property is sold at a foreclosure sale or to a third party, the partnership abandons property (such as by quit claim deed or a tax sale), or the partnership reconveys the property to the lender (that is, deed in lieu of foreclosure), it may realize COD income or realize a gain or loss on the disposition, or a combination of both.  This determination will turn on the nature of the debt involved, that is, non-recourse or recourse, see Chapters 3 and 6 for additional information on recourse versus. non-recourse liabilities. The determination of the existence or amount of COD income and the amount of sale/exchange gain or loss are both made at the partnership level. If debt is discharged and the payment of the debt would have given the taxpayer a deduction, then the taxpayer does not realize COD income under IRC section 108(e)(2).  For example, when a cash basis taxpayer’s obligation to pay an expense is cancelled. If seller financed debt is reduced for a solvent taxpayer, the reduction is treated as a purchase price reduction.  It is not considered COD income. IRC section 108 (e)(5). Each partner’s distributive share of COD income and sale or exchange gain is separately stated on his or her Schedule K-1. Partners must include COD income in taxable income unless an exception applies (IRC section 61(a)(12)).  The taxability of COD income is determined at the partner level (IRC sections 108(d)(6) and 6231(a)(5)). In addition to the summary report an affected item report must be prepared because additional factual determinations are required at the partner level. A partner may exclude COD income under IRC section 108 if: Partner is bankrupt (Title 11 discharge-See sub-chapter B) Partner is insolvent (limited to level of insolvency) Qualified farm indebtedness is cancelled Debt is Qualified Real Property Business Indebtedness (“QRPBI”), the partner is not a C corporation, and the partner elects to reduce basis in depreciable real property. Note:  If more than one of these exceptions apply, they are applied in the above order.  IRC section 108(a)(2)(A). back to the top Non-Recourse Debt Property Dispositions: (that is, Foreclosures, Abandonments, Sales, etc.) COD income is not realized when property that secures non-recourse debt is disposed/sold (that is, sale, foreclosure, deed-in-lieu of foreclosure, abandonment, etc.).  The non-recourse obligation is considered the amount realized (that is, sales proceeds) (Tufts v. Commissioner, 461 U.S. 300 and IRC section 7701(g)).  It does not matter that the fair market value is equal to or less than the amount of the debt. Property Retained-Debt Reduced If the debtor retains the property and the creditor reduces non-recourse debt, COD income will be realized (Gershkowitz v. Commissioner, 88 T.C.984 (1987) and Rev. Rul. 91-31) Property Sold and Debt Discharged The following sequence of events are considered part of one overall sales transaction: Partnership sells a building subject to non-recourse debt to a third party. The sales proceeds go to the lender. The lender discharges the difference between the debt and the sales proceeds. The lender settles a partner’s personal guarantee for a lesser amount. In this transaction, the amount realized will equal the amount of the non-recourse debt less the amount required to be paid by the guarantor.  (2925 Briarpark, Ltd., TC Memo 1997-298, aff’d 99-1, Par. 50,209, (5th Cir.) Recourse Debt Property Dispositions COD income may be realized when property that is security for recourse debt is disposed/sold.  If recourse debt cancelled is more than the FMV/sales price of the property, the difference is treated as COD income.  If recourse debt is equal or less than the FMV/sales price of the property, no COD income is realized.  The difference between the FMV/sales price and adjusted basis of the property will be treated as gain or loss on sale/disposition of property (IRC section 1001(a)). back to the top                Property Retained-Debt Reduced If the debtor retains the property and the creditor reduces recourse debt, COD income will be realized. xceptions Bankruptcy See Issue D in this chapter. Insolvency If a partner is insolvent, then he or she may exclude COD income to the extent insolvent (IRC section 108(a)(1)(B) and IRC section 108(a)(3).  If the cancellation of debt removes a partner from insolvency, the partner must recognize income to the extent made solvent.  That is, to the extent the fair market value of the partner’s assets exceeds his or her liabilities immediately after the cancellation. Insolvency is determined immediately before discharge of debt (IRC section 108(d)(3)). The amount by which a non-recourse 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, but only to the extent that the excess non-recourse debt is discharged.  Rev. Rul. 92-53. The fair market value of assets that are exempt under state law are not excludable in determining insolvency. Contingent liabilities (guarantees) are not included in the insolvency computation.  Merkel, 109 T.C. 463 (1997), aff’d, 99-2 U.S.T.C. Par. 50,848 (9th Cir. 1999). The burden of proving insolvency is on the taxpayer.  Bressi, T.C. Memo 1991-651. INSOLVENCY COMPUTATION: Fair Market Value of Assets (less selling costs) • Cash • IRAs/Pensions • Life insurance (cash surrender value) • Personal property • Real property • Stocks, Bonds, & Other Securities • Business interests (Partnerships, S-Corporations, LLCs, etc.) • Accounts/Notes Receivable Less: Liabilities • Recourse Debt • Non-recourse Debt        = (Insolvency) / Solvency Tax Attribute Reduction-Insolvent and Bankrupt Partners If cancelled debt is excluded under IRC section 108 because a partner is bankrupt or insolvent, he or she must use the excluded amount to reduce net operating losses, capital losses, basis, suspended passive losses, and other tax attributes. Qualified Farm Indebtedness Must be done by a “Qualified Person” and the taxpayer must have sufficient tax attributes (IRC section 108(g)). Qualified Real Property Business Indebtedness Solvent partners, other than C corporations, may exclude cancellation of Qualified Real Property Business Indebtedness (“QRPBI”) income if certain requirements are met (IRC section 108(c)). The determination of whether cancelled debt is QRPBI is made at the partnership level. The debt cancelled must be secured by real property used in the trade or business and incurred before January 1, 1993, or be Qualified Acquisition Indebtedness. The excluded COD income cannot exceed the partner’s share of the difference between the outstanding principal amount of debt (before discharge) and the fair market value of the real property (reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property); and the partner’s total adjusted bases of depreciable real property.  The outstanding principal amount includes prior year accumulated accrued and unpaid interest (Final Treas. Reg. section 1.108-6(a)). back to the top The adjusted basis of qualified real property (whose debt was reduced) must be reduced by discharged QRPBI before the adjusted bases of other depreciable real property are reduced (Final Treas. Reg. section 1.1017-1(c)(1)). The basis of property acquired in contemplation of cancellation of indebtedness may not be reduced. The partner must make a timely election to reduce the bases of his or her depreciable real property (Note:  Depreciable real property does not include land, furniture and fixtures, equipment or intangible assets).  A partnership interest is considered depreciable real property to the extent of the partner’s share of depreciable real property. To make the election, the partner uses Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness in the year COD income is received.  The partner must attach a detailed description, by property, identifying any reduction in basis under IRC section 1017. For the partner’s basis in his or her partnership interest to be reduced the partnership must make a corresponding reduction in the partner’s share of depreciable real property on its books.  If the partnership does not make the reduction, then the partner may not exclude the COD income (See Treas. Reg. section 1.1017-1(g)(2) for general rule and exceptions). The partnership must consent to the reduction of partner’s share of inside basis if- The partner owns (directly or indirectly) more than 80 percent interest in the capital and profits of the partnership, or Five or fewer partners own (directly or indirectly) an aggregate of more than 50 percent of the capital and profits interests of the partnership (See Treas. Reg. section 1.1017-1(g)(2)(ii)(C)). Partnership Consent Statement (Treas. Reg. section 1.1017-1(g)(2)(iii)) back to the top Partnership Requirement: Statement must be attached to partnership return (Form 1065) for the taxable year following the year that ends with or within the taxable year the partner excludes COD income. Statement must be provided to the partner on or before the due date of the partner’s return (including extensions) for the taxable year in which the partner excludes COD income. Statement must contain the following: Name, address, and taxpayer identification number of the partnership; and States the amount of the reduction of the partner’s proportionate interest in the adjusted bases of the partnership’s depreciable real property. Partner Requirement: The partnership consent statement must be attached to the partner’s timely filed (including extensions) tax return for the taxable year in which the partner excludes COD income. If the property whose debt is reduced is sold in the same year as the debt cancellation, IRC section 1017 (a)(3)(F) requires that the basis reductions be effected immediately before the sale.  As a result, basis reductions will be immediately triggered into income (as ordinary income due to IRC section 1245) upon the sale (IRC section 1017(b)(3)(F)(iii)).  This immediate recapture normally will take any tax benefit away from IRC section 108(c). Accrued Interest Expense See sub-chapter B for the treatment of accrued unpaid interest when a property secured by non-recourse debt is sold/foreclosed.  See sub-chapter C for the treatment of accrued unpaid contingent interest. If debt is cancelled during the year, current year accrued interest is not allowable.  If interest has been accrued during the year and it will never be paid, there is no fact of liability.  The all events test has not been met (IRC section 461(h)(4)).  In addition, IRC section 108(e)(c)(2) says to ignore items that would give rise to a deduction. The outstanding principal amount of QRPBI includes prior year accumulated accrued unpaid interest expense (Treas. Reg. section 1.108-6(a)). back to the top Passive Activity Loss Limitations COD Income Excluded under IRC section 108(a)(1)(A), (B), (C): Cancelled debt that is not taxed because a taxpayer is bankrupt (Title 11), insolvent, or has qualified farm indebtedness discharged cannot be passive income on Form 8582 (Passive Activity Loss Limitations) line 1a or 2a.  Passive income is only income that is taxed in the current year.  If cancelled debt is taxable income under IRC section 61(a)(12), then it may be passive income. However, COD income that is excluded under IRC section 108(a)(1)(A), (B), or (C) shall be applied to reduce tax attributes of the taxpayer (IRC section 108(b)).  Passive activity loss and credit carryovers are considered tax attributes.  Tax attributes (including passive activity losses and credits) that are reduced may never be deducted by the taxpayer. Taxable COD Income (IRC section 61(a)(12) and Gain on Foreclosure or Sale (IRC section 61(a)(3): Generally taxable COD income is passive to the extent it is allocated to passive activity expenditures at the time the debt is discharged (Rev. Rul. 92-92).  A similar rationale can be applied to gain on foreclosure or sale of property. There are some exceptions to this general rule.  In the following cases COD income or gain on foreclosure or sale of property should be considered non passive income and should not be on Form 8582 line 1a or 2a: Partner is a real estate professional and materially participated in the partnership rental activity in the year income or gain is recognized. See IRC section 469(c)(7) and Treas. Reg. section 1.469-9. COD Income and/or gain on foreclosure or sale of property is non-passive if the property was leased to an entity where the investor worked (that is, materially participated – the self-rental recharacterization rule).  See Treas. Reg. section 1.469-2(f)(6). COD Income and/or gain on foreclosure or sale of property are non-passive if less than 30 percent of the unadjusted basis is depreciable.  Income from land, whether held for investment or leased or sold, is non-passive.  See IRC section 469(e)(1)(A)(ii)(II) and Treas. Reg. section 1.469-2T(f)(3). In the year of disposition, COD income and/or gain on foreclosure or sale of property is recognized but the partnership is not a rental activity or business.  See Treas. Reg. section 1.469-2T(c)(2)(A)(I)(3).  Whether or not property is rented in the year of disposition is easy to determine.  Simply review Form 8825 for rental income and/or advertising expense. Even if COD income and/or gain on foreclosure or sale of property is determined to be passive, it does not belong on Form 8582, triggering unrelated passive losses, if current and suspended losses from the activity disposed of exceed income/gain reported from the activity. See IRC section 469(g). IRC section 469(g) permits the deductibility of all current and suspended losses IF there is an entire disposition of a partnership interest in a fully taxable transaction to an unrelated party.  Thus, whether or not the character of income attributable to cancelled debt and/or gain on foreclosure/sale is passive or non passive, all losses (current and suspended) from the partnership will be deductible.  If the amount or timing of COD income and/or gain on foreclosure/sale has yet to be determined, there is not a “fully taxable” disposition (that is, all gain/loss realized and recognized) as required by IRC section 469(g).  Any legitimate passive income will, of course, trigger deductibility of losses. While Revenue Ruling 92-92 generally provides that COD income from a passive activity in the taxable year of disposition IS passive income, the rules for real estate professionals were enacted beginning in 1994, 2 years later.  If a taxpayer is a real estate professional (spends majority of his time on real property businesses and/or rentals) and he or she materially participates in the rental activity disposed of (performs most of the work or more than anyone else does), income will be non-passive.  See IRC section 469(c)(7) and Treas. Reg. section 1.469-9.  In other words, gain on foreclosure or sale and COD income, while still reportable, may not be used on Form 8582 line 1a or 2a to trigger unrelated passive losses.  Under IRC section 469(f), however, the COD income/gain will trigger losses from the same activity.  Even if the activity is not disposed of and debt related to the activity is cancelled, it will trigger losses from the same activity, but not from unrelated activities. Additional guidance may be found in the MSSP Passive Activity Guide.  You can also contact the Passive Activity Issue Specialist. back to the top Examination Techniques The following determinations need to be made during the examination: Whether the partnership realized COD income. Whether the partnership correctly reported COD income. Whether COD income should be recharacterized as gain on disposition of partnership property. Whether the partnership improperly deducted accrued unpaid interest expense in the year the debt was cancelled. Whether the partnership deducted accrued unpaid contingent interest expense and/or included it in COD income (see sub-chapter C). Whether partners correctly report COD income and/or reduced tax attributes.  (Note: Since additional factual determinations are required at the partner level, an affected item report will need to be prepared.) Scrutinize any depreciable real property acquisitions within 18 months of the receipt of COD income.  Interview the taxpayer and lender to determine whether any substantial discussions regarding restructuring partnership debt were held prior to the acquisition of depreciable real property.  If there were, the basis of recently acquired depreciable real property may not be reduced in lieu of reporting cancelled QRPBI income. As part of determination of whether debt is recourse or non-recourse, inspect prior year partnership return and Schedules K-1 to see how debt was classified.  Balance sheet of partnership return has a non-recourse debt line.  However, some partnerships may enter non-recourse debt on the mortgage line of the balance sheet, but also reflect it on the Schedule K-1 as Qualified Non-recourse Financing. Issue Identification COD and Basis Reduction: Balance sheet of partnership tax return shows a substantial decrease in liabilities at year-end.  This may indicate cancellation of indebtedness income.  Real estate partnerships will frequently renegotiate mortgages when the value of real property declines. Other income shown on Schedule K may be COD income. Instead of showing COD income on the individual partner’s Schedule K-1 there may be a supplemental statement suggesting that the partner consult their tax advisor on how to report the reduction in debt. Analysis of “old” and “new” loan documents will indicate amount of COD and whether debt is secured by real property.  For a partner to exclude COD income under the QRPBI exception, the debt must be secured by real property and the security must be recorded. An appraisal will indicate whether the debt cancelled exceeds the difference between the amount of debt and the fair market value of the real property.  The QRPBI exception does not apply to the excess debt cancellation.  Therefore, the excess will be taxable income. If solvent partners elected to reduce basis in their partnership interests rather than report COD income (QRPBI exception), the partnership tax return for the year subsequent to the debt discharge should be inspected.  The balance sheet of the partnership return should show a decreased basis in real property and the Schedules K-1 should include a statement indicating the amount by which the partners should adjust income for the basis decrease.  If partners elected to reduce basis in other depreciable real property (not owned by the partnership), there would not be a statement on the subsequent year Schedules K-1. Analysis of interest expense worksheets/schedules will indicate whether the partnership has improperly accrued interest expense in the workout year. Accrued unpaid interest should not be deducted or included in COD income. COD versus Sale: If the partnership reports a sale of property and COD income, analyze all loan documents to determine whether loan was non-recourse or recourse.  If the loan is determined to be non-recourse, analyze all sales documents to determine whether there were two transactions or one interrelated transaction.  If it is determined that there was one transaction, then the full amount of non-recourse debt should be treated as sales proceeds.  2925 Briarpark Ltd., TC Memo 1997-298, aff’d 99-1, Par. 50,209, (5th Cir.). If inspection of the partnership return indicates that COD income was reported, property decreased on the balance sheet, and a loss/very small gain/ or no gain on sale of partnership property was reported, determine whether partnership properly reported transaction. Analyze all loan and purchase/sales documents.  If a guarantee of non-recourse debt was made at the eleventh hour, it may not change the status of the loan from non-recourse to recourse.  For example, if the guarantee provides that a partner must repay the loan only if he fights the foreclosure sale, this would be considered a contingent guarantee and would not change the loan from non-recourse to recourse.  If you have an 11th hour guarantee issue, call a Partnership Technical Advisor. back to the top Documents to Request Partnership Agreement and all amendments. Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees and/or loan indemnification agreements. If the loan has been restructured, provide all documents relating to the amended and restated loans. Copies of all purchase/sales documents and settlement sheets. All workpapers, schedules, and documents used to determine amount of cancellation of indebtedness income. Copies of Forms 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Copies of Forms 1065, U.S. Partnership Return of Income, for subsequent year. QRPBI Issues-Additional Documents to request: (a) All workpapers, schedules, and documents used to determine amount of cancellation of indebtedness income, fair market value of partnership property at time debt was cancelled, and each partner’s allocable share of depreciable partnership property. (b) Copies of partners’ requests to General Partner to reduce basis of partnership property. (c) Copies of partnership’s consents allowing partners to reduce basis of partnership property. (d) Copies of partner’s elections (Form 982) to reduce the basis of depreciable real property by their distributive share of the Cancellation of Indebtedness Income.  If a partner has reduced basis of property other than partnership property, provide street address of property, percentage ownership, date acquired, cost, depreciable life and remaining adjusted basis at 12/31/XX.  In addition, if any of this property is owned by partners as partners in other partnerships, also provide the complete partnership name and address, tax identification number, name of contact person, telephone number and copy of the subsequent year Schedule K-1 received from this entity. (e) Any appraisal of partnership property by the old or a new lender and/or by the partnership. Interview Questions Depending upon the documents provided by the partnership, the following questions might have to be asked. Was any partnership debt cancelled/reduced/refinanced/restructured? Was partnership debt recourse or non-recourse?  Were there any guarantees/indemnification agreements?  Was the lender advised of the guarantees/indemnification agreements? Was partnership property sold? How did the partnership determine COD income? How did the partnership determine the gain on disposition of property? Did the partnership make all principal and interest payments in the current/prior years?  If not, what was the amount of interest that was not paid in current/prior years?  Were there any standstill/forbearance agreements regarding the payment of interest? (QRPBI issue) How did the partnership determine the FMV of partnership property? (QRPBI issue) Which partners requested a reduction in their share of partnership property? (QRPBI issue) Did the partnership consent to the allowance of all partners’ requests for reduction in basis of partnership property? back to the top Supporting Law General rule-IRC section 61(a)(12) IRC section 61(a)(3) IRC section 108 Exclusion IRC section 469 and related Regulations IRC section 1017 IRC section 6231(a)(5) IRC section 461(h)(4) IRC section 7701(g) Sections 108 and 1017 final Treasury Regulations (applies to discharges after October 22, 1998) and related regulations: Final Treas. Reg. section 1.108-4 Election to reduce basis of depreciable property under section 108(b)(5) of the Internal Revenue Code. Final Treas. Reg. section 1.108-6 Limitations on the exclusion of income from the discharge of qualified real property business indebtedness. Final Treas. Reg. section1.1017-1 Basis reductions following a discharge of indebtedness. Treas. Reg. section 301.9100-2 Late Election filed with amended tax return within 6 months of the due date of the original return (excluding extensions) Treas. Reg. section 301.9100-3 Requests for extension that do not meet the requirements of Treas. Reg. section 301.9100-2.  Taxpayer must prove that he/she acted in good faith, acted reasonably, and that the grant of relief will not prejudice the Government’s interests. Rev. Rul. 91-31.  The reduction of the principal amount of an undersecured non recourse 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 IRC section 61(a)(12). Rev. Rul. 92-53. The amount by which a non-recourse 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 IRC section 108(d)(3), but only to the extent that the excess non-recourse debt is discharged. Rev. Rul. 92-92. COD income is passive income to the extent it is allocated to passive activity expenditures at the time the debt is discharged. Kirby Lumber, 284 U.S. 1 (1931).  Corporation that purchased its own bonds at a discount on the open market realized COD income. Tufts, 461 U.S. 300 (1983) and IRC section 7701(g).  FMV of property securing non-recourse debt shall be treated as not less than the amount of the debt. Gershkowitz v. Commissioner, 88 T.C. 984 (1987).  COD income was realized when non-recourse debt was canceled and debtor retained property. Merkel, TC Memo 1954-82.  Insolvency is the amount by which the taxpayer’s liabilities exceed the FMV of the taxpayer’s assets immediately before the discharge. Merkel, 109 T.C. 463 (1997), aff’d, 99-2 USTC Par. 50,848 (9th Cir. 1999).  Taxpayers were not allowed to include contingent liabilities (guarantees) in their insolvency computation. Bressi, TC Memo 1991-651.  The burden of proving insolvency is on the taxpayer. 2925 Briarpark, Ltd., TC Memo 1997-298, aff’d 99-1, Par. 50,209, (5th Cir.).  Partnership sold a building subject to non-recourse debt to a third party.  The sales proceeds went to the lender who discharged the difference between the debt and sales proceeds.  The partnership argued that two transactions had taken place.  A discharge of indebtedness where the partnership retained the property, and a subsequent sale.  Both courts agreed that there was only one transaction, a sale/exchange and the sales proceeds equaled the amount of the non-recourse debt (Tufts and IRC section 7701(g)).  Also, the courts treated the difference between the portion of the debt that was guaranteed and the amount paid to settle the guarantee as Tufts gain. The fair market value of assets that are exempt under state law are not excludable in determining insolvency. Resources BNA, Tax Management Portfolio 541 “A Requiem for Fulton Gold”, Taxes, (July 1994) IRS-Publication No. 541, “Partner’s Exclusions and Deductions” MSSP Passive Activity Guide “Contingent Debt Taken into Account in Determining Insolvency”, The Tax Adviser, (March, 1999) “IRS Finalizes Regs. On Basis Reduction Excluded DOI Income”, The Tax Adviser, (March, 1999) back to the top ISSUE:  DISPOSITION OF PROPERTY SUBJECT TO NON-RECOURSE DEBT AND UNPAID INTEREST When real property subject to non-recourse debt is disposed/sold (that is, sale to third party, involuntary foreclosure sale, deed in lieu of foreclosure, abandonment of property subject to non-recourse debt, etc.), the outstanding mortgage debt is considered sales proceeds (Tufts v. Commissioner, 461 U.S. 300 and IRC section 7701(g)).  Therefore, the gain (IRC section 1001(a)) will equal the difference between amount of the debt (Treas. Reg. section 1.1001-2(a)(1)) and the adjusted basis of the property regardless of the property’s fair market value.  In most cases the gain will be treated as capital gain (IRC section 1231) by the partners, unless part/all of the gain has to be treated as differently due to the following provisions: IRC section 1245 - All depreciation on IRC section 1245 property is treated as ordinary income. IRC section 1250 - Excess depreciation above straight-line depreciation is recaptured as ordinary income. Unrecaptured IRC section 1250 gain - For sales of depreciable real property after May 7, 1997, depreciation not recaptured under IRC section 1250 as ordinary income is taxed at 25 percent (straight line depreciation) under IRC section 1(h). Unrecaptured IRC section 1231 losses - Any current year net IRC section 1231 gain, which would otherwise be characterized as capital gain, will be treated as ordinary income to the extent it does not exceed non-recaptured net IRC section 1231 losses.  Non-recaptured net IRC section 1231 losses are the aggregate amount of net IRC section 1231 losses for the 5 most recent preceding taxable years reduced by any amount already recaptured in a prior year.  This issue would not be raised at the partnership level, but is an “affected item” to be determined by reviewing the individual partner’s preceding five income tax returns for the existence of unrecaptured net section 1231 losses (that is, an affected item report must be prepared). IRC section 111 - Tax Benefit Rule may be cited to treat accumulated unpaid accrued interest expense and real estate taxes that will not be paid on the disposition of real estate financed by non-recourse debt as ordinary income.  When real estate is sold at a foreclosure sale, a partnership abandons property (tax sale or quit claim deed), or the partnership reconveys the property to the lender (that is, deed in lieu of foreclosure), there will normally be little or no cash available to pay the accumulated unpaid accrued interest and real estate taxes.  If real estate is sold and the sales proceeds are sufficient to pay off the outstanding debt, accumulated unpaid accrued interest, and accumulated unpaid real estate taxes, then IRC section 111 does not apply. back to the top Unpaid Accrued Interest IRC section 163 provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. Unpaid current year accrued interest is not allowed in the year of disposition (IRC section 461(h)).  IRC section 461(h)(1) provides: For purposes of this subtitle, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs. IRC section 461(h)(4) provides: For purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy. Treas. Reg. section 1.461-4(e) provides that economic performance occurs as the interest economically accrues. At the time of disposal or sale of the property, there is no liability to pay any interest.  If interest has been accrued during the year and it will never be paid, there is no fact of liability. Prior year accrued unpaid interest expense should be recaptured as ordinary income to the extent of Tufts gain (loan balance +accrued interest-adjusted basis). IRC section 111(a) provides that “Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.” Therefore, a taxpayer that has deducted an expense in a prior year and received a tax deduction (that is, tax benefit) for the expense should have to recapture the expense in income in the year it is determined the expense will never have to be paid. Examination Techniques To determine whether the partnership has deducted accrued unpaid interest expense, inspection and analysis of loan documents, loan payment histories, and interest expense schedules/workpapers is required. Issue Identification Comparison of the current and prior year partnership tax return balance sheet shows an increase in liabilities.  This may be due to the accrual of unpaid interest expense. A schedule attached to the partnership tax return may list an account called “Accrued Interest Payable.” Documents to Request Partnership Agreement and all amendments Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees and/or loan indemnification agreements. Copies of all purchase/sales documents and settlement sheets. All workpapers, schedules, and documents used to determine amount of interest expense deduction Copy of audited financial statements. Copies of Forms 1065, U.S. Partnership Return of Income, for prior and subsequent year. Interview Questions In the year of disposition of partnership property did the partnership deduct accrued and unpaid interest?  If yes, what was the amount of the deduction? Did the partnership include accumulated accrued and unpaid interest expense in the amount realized upon disposition of the partnership property?  If yes, what was the amount included? Supporting Law IRC section 111 IRC section 163 IRC section 461(h) IRC section 1001(a) IRC sections 1231, 1245, & 1250 IRC section 7701(g) Treas. Reg. section 1.461-4(e) Treas. Reg. section 1.1001-2(a) Tufts v. Commissioner, 461 U.S. 300, and IRC section 7701(g) ─ The non-recourse obligation is considered sales proceeds. Allan, et al. v. Commissioner, 86 TC 655, U.S. Court of Appeals, 8th Circuit, 86-2268, September 16, 1988, 856 F.2d 1169 ─ If debt is with a new lender or there is a third party guarantor, then IRC section 111 interest income issue can be raised, except in the 8th Circuit. McConway & Torley Corp. v. Commissioner, 2 T.C. 593. Shellabarger Grain Products Co., 2 T.C. 75. Courts did not allow deduction for current year unpaid accrued interest in year debt was canceled. Theodore A. Frederick, et al. v. Commissioner, 101 T.C. 35 ─ This case provides an excellent background on the tax benefit rules (IRC section 111).  However, the facts in this case do not deal with the disposition of real property subject to non-recourse debt. Hillsboro Natl. Bank v. Commissioner, 460 U.S. 370 (1983) ─ Background on tax benefit rules (IRC section 111).  Referred to in Frederick. Resources Publication 544 - Sales and Other Dispositions of Assets See Accrued Interest back to the top ISSUE:  ACCRUED CONTINGENT INTEREST In situations where an accrual basis borrower is having difficulty making loan payments a lender may modify the non-recourse loan terms.  For example, a lender may require that interest be paid only to the extent of available cash flow and any unpaid balance will be payable in the future.  In other words the lender will only be paid the “accrued” interest if the property securing the non-recourse debt appreciates in value sufficiently to pay it out of sales or refinancing proceeds.  This type of loan modification is called a Standstill or Forbearance Agreement. In some cases the lender won’t modify a non-recourse loan and the borrower will accrue, deduct and fail to pay interest year after year. As previously discussed, interest could only be accrued and deducted in the year that the liability to pay becomes definite and absolute, regardless of the actual time of payment (IRC section 461(h)(1) and (4), Treas. Reg. section. 1.461-4(e)). If the obligation to pay interest is wholly contingent upon the happening of a subsequent event (that is, cash flow, profitability, etc.) that can be manipulated, then interest may not be accrued and deducted until the contingency is satisfied. In Pierce Estates, Inc. v. Commissioner, 195 F.2d 475 (3rd Circuit 1952) the taxpayer used the accrual method of accounting.  Interest was payable only if the company had “net income that was declared by board of directors” (contingency).  In its conclusion, the court stated: If the liability to pay the item of expense is wholly contingent upon the happening of a subsequent event, the item cannot be regarded as incurred or deductible as accrued until the year in which by the occurrence of the event the contingent liability becomes and absolute one. In Peoples Bank & Trust Co., 50 T.C. 750, the bank paid interest on deposits on May 1st and November 1st.  Interest paid on May 1st was contingent upon whether funds were still on deposit as of close of business on April 30th.  The bank used the accrual method of accounting and the calendar year.  An “experience” factor was used to calculate interest expense deducted for November and December.  The Tax and Appeals Courts determined that the bank had no liability for interest until May 1st.  Therefore, the “all events test” had not been met and the deduction for interest expense was disallowed.  In addition, a change in accounting method (IRC section 481) adjustment was made In Burlington-Rock Island Railroad Company, 321 F.2d 817, the taxpayer used the accrual method of accounting.  It entered into an “Allocation Agreement” that required payments on judgements owed “*** from time to time, insofar as its cash situation will reasonably permit.”  It accrued an interest deduction.  However, the interest was not paid.  The judge denied Burlington’s interest deduction. In situations where there is no Standstill or Forbearance Agreement and the borrower has been in default (that is, not paying the required principal and interest on the non-recourse loan) for multiple years, the liability to pay interest will be considered subject to a contingency.  However, prior to considering whether the interest payment is subject to a contingency the examiner should determine if a “true” debt exists (that is, debt versus equity). The accrual of interest expense involves the timing of claiming a deduction (Treas. Reg. section 1-446-1(e)(2)).  If it is determined that interest expense has been improperly deducted, then a change in the taxpayer’s method of accounting should be made.  In addition to the current year disallowance of the contingent interest expense deduction a cumulative adjustment will need to be made for the contingent interest expense improperly deducted on prior year returns (IRC section 481(a) adjustment).  This adjustment prevents the duplication of the expense and reflects the difference between the “new” and “old” treatment of interest expense as of the beginning of the year of change.  The IRC section 481(a) adjustment should be made in the earliest year of the examination and no 4-year spread should be allowed (Notice 98-31 and Rev. Proc. 97-27). If a positive IRC section 481(a) adjustment over $3,000 is made, then the adjustment is subject to IRC section 481(b) and the related regulations.  IRC section 481(b) provides that the additional tax (increase in tax) attributable to the IRC section 481(a) adjustment is the lesser of the increase in tax computed: With the net adjustment (IRC section 481(a)) included in income in the year of change Under the 3-year (spread-back) allocation rule of IRC section 481(b)(2) Under the specific allocation rule of IRC section 481(b)(2) Since the IRC section 481(b) computation will be made at the partner level and requires additional factual determinations, an affected item report must be prepared (Treas. Reg. section 1.481-2(c)(5). Examination Techniques To determine whether the partnership has deducted accrued contingent interest expense, inspection and analysis of standstill/forbearance agreements, loan documents, loan payment histories, and interest expense schedules/workpapers is required. Issue Identification Comparison of the current and prior year partnership tax return balance sheet shows an increase in liabilities.  This may be due to the accrual of contingent interest expense. A schedule attached to the partnership tax return may list an account called “Accrued Interest Payable.” Review of financial statements may indicate that partnership is not deducting contingent interest expense on financial statements, but is deducting it on tax returns.  Notes to financial statements may identify the standstill/forbearance agreement, etc. that requires the partnership to pay interest only when it has cash flow. back to the top Documents to Request Partnership Agreement and all amendments Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees, /or loan indemnification agreements, standstill/forbearance agreements. All workpapers, schedules, and documents used to determine amount of interest expense deduction Copy of audited financial statements. Copies of Forms 1065, U.S. Partnership Return of Income, for prior and subsequent year. Interview Questions Did the partnership deduct accrued and unpaid interest?  If yes, what was the amount of the deduction? Why didn’t the partnership pay interest? Was there an agreement between the lender and the partnership that permitted the nonpayment of interest until there was cash flow, profitability or until some other contingency was satisfied? What was the amount of the accumulated accrued and unpaid interest expense deducted on prior year tax returns? Supporting Law IRC section 163 IRC section 446 and related regulations IRC section 461 IRC section 481 and related regulations Notice 98-31 Rev. Proc. 97-27 Pierce Estates, Inc. v. Commissioner, 195 F.2d 475 (3rd Circuit 1952) Peoples Bank & Trust Co., 50 T.C. 750. Burlington-Rock Island Railroad Company, 321 F.2d 817 Resources Change in Accounting Method Technical Advisor. ISSUE:  BANKRUPTCY A financially troubled partnership and/or partner may file a petition in bankruptcy court.  Bankruptcy is a condition existing as the result of the actual filing of a petition under the Bankruptcy code.  The bankruptcy statutes are contained in Title 11 of the United States Code.  They provide the structure within which an individual, a partnership, or a corporation can seek relief from creditors through liquidation or reorganization. There are five chapters in the bankruptcy code under which bankruptcy proceedings are commenced, administered and closed.  They are: Chapter 7 – Liquidation Chapter 9 – Adjustment of the Debts of a Municipality Chapter 11 – Reorganization Chapter 12 – Adjustments of Debts of a Family Farmer with Regular Annual Income Chapter 13 – Adjustments of Debts of an Individual with Regular Income A bankruptcy under any chapter may be voluntary or involuntary.  It is voluntary if the debtor files the petition and involuntary if the creditors file the petition.  A debtor does not have to be insolvent to file a bankruptcy petition.  With the commencement of a bankruptcy proceeding, an automatic stay is triggered.  It precludes a creditor from continuing collection activities against the debtor.  Thus, a debtor with cash flow problems may file for bankruptcy protection.  A bankruptcy stay will stop foreclosure actions and many IRS assessment and collection actions. Most partnership and partner bankruptcies are filed under Chapter 11 and Chapter 7.  Title 11 encompasses both chapters.  It is necessary to determine which Chapter the taxpayer actually filed under to determine the tax consequences.  Both will be discussed in more detail. back to the top Bankruptcy Basics Per IRM 4.10.3.1.3: Chapter 7 – Liquidation:  A bankruptcy case in which all of the debtors (individual, corporation, or partnership) non-exempt assets are liquidated (sold) by the trustee to pay creditors’ claims or are abandoned.  The petition may be voluntarily or involuntarily filed.  Typically, the debtor has no hope of continuing business operations and/or paying debts. Chapter 11- Reorganization:  A bankruptcy case in which debtors (individual, corporations, or partnerships) are allowed to restructure (reorganize) their debts, either by reducing their debts and/or extending the time for payment rather than liquidate.  To be confirmed by the Bankruptcy Court, the reorganization plan must be proposed in good faith and the creditors must be paid at minimum an amount equal to what they would have received had the case been filed a Chapter 7-liquidation bankruptcy.  The debtor usually remains in possession of the assets (called a debtor- in-possession or DIP) and has the same fiduciary duties and responsibilities as a trustee to general creditors.  A trustee can be appointed by the Bankruptcy Court if the creditor can show cause. A debtor may also choose to liquidate its assets in a Chapter 11 case. Frequently a debtor will file under Chapter 11 and convert to a Chapter 7. The Administrative Office of the United States Courts in Washington, D.C. publishes a Bankruptcy Division Public Information Series.  There is an information sheet for each of the Bankruptcy Chapters that discusses the basic concepts.  The sheets are available from the local District Bankruptcy Court.  The following information is taken from them: Chapter 7  “One of the primary purposes of bankruptcy is discharging debts to give an honest individual debtor a “fresh financial start”.  The discharge has the effect of extinguishing the debtor’s personal liability on dischargable debts.  In a chapter 7 case, however, a discharge is available to individual debtors only, not to partnerships or corporations (11 U.S.C. section 727(a)(1)).  Although the filing of an individual chapter 7 petition usually results in a discharge of debts, an individual’s right to discharge is not absolute.  A bankruptcy discharge does not extinguish a lien on property.” “The primary role of a chapter 7 trustee in an “asset” case is to liquidate the debtor’s nonexempt assets in a way that maximizes the return to the debtor’s unsecured creditors *** the trustee will attempt to liquidate the debtor's nonexempt property.  This includes both property that the debtor owns free and