One of the hard concepts to teach students is the different tax treatments for recourse loans and non-recourse loans. It gets especially confusing when the sale of underwater property includes a Discharge of Indebtedness (DOI) as part of the sale. In Michael G. Parker and Julie A. Parker v. Commissioner, T.C. Memo. 2023-104 (Aug. 10, 2023) (Judge Nega), we learn that discharge of non-recourse debt as a result of a property sale cannot generate DOI income (and thus cannot qualify for exclusion under §108) but must instead be used in calculating gain from the sale.
In today’s case the taxpayer’s S Corporation sold some underwater property and the deal included a discharge of part of the unpaid debt. They argued that they were insolvent at the time of the deal and thus attempted to exclude the DOI from income under the insolvency exclusion allowed by §108(a)(1)(B). But because the cancelled debt was non-recourse, the taxpayers could not use §108. Instead, the amount discharged had to be included in the calculation of gain and thus §108 could not apply. It’s a basic, yet complex, lesson. Details below the fold.
Law: Of Loans, DOI Income, and Recourse and Non-Recourse Loans
A loan is not income when made. But a taxpayer will have income to the extent the taxpayer is later relieved of the obligation to repay. Two interchangeable terms—Cancellation of Debt (COD) and Discharge of Indebtedness (DOI)—describe that event. Here I’ll use DOI.
No one really knows why DOI is income. There is no single reason. For those who want more on that, see Lesson From The Tax Court: The Phantom Of The Tax Code—Discharge Of Indebtedness, TaxProf Blog (Feb. 19, 2018).
Most taxpayers are surprised to learn that DOI is income. They don’t usually feel wealthier; they just feel...well...relieved. Less desperate. That very desperation, however, can provide a basis for excluding DOI from gross income because §108(a)(1)(B) allows taxpayers to exclude DOI when they are insolvent. As we learned in a different lesson, the exclusion is limited to the amount of the insolvency at the time of the discharge. For example, if a taxpayer is discharged from $10,000 of debt at a time when the taxpayer is insolvent by $6,000, then the taxpayer can exclude $6,000 of the DOI from income but must report the remaining $4,000 as gross income, assuming no other exclusion applies. §108(a)(3). See Lesson From The Tax Court: How To Calculate Insolvency For The §108 Exclusion, TaxProf Blog (June 26, 2023).
Complications arise, however, when the DOI is associated with the sale of underwater property. That happens when the property was purchased with the loan and the loan balance is more than the amount of cash or other consideration the taxpayer receives for the property on the sale. The reason this gets complicated is because loans used to buy property come in two flavors: recourse or nonrecourse. The difference in loan type makes a huge difference in the tax consequences of being discharged from the debt when the property is sold.
Non-recourse loans are those that limit the lender’s ability to enforce repayment. They permit the lender to obtain repayment from only those assets the lender uses to secure the loan, generally the property being purchased. In contrast, recourse loans are those that give the lender open season (recourse) to any and all of the debtor’s assets to effectuate repayment.
Non-recourse loans cannot generate DOI on the sale of underwater property. That is because the discharge of indebtedness is deemed to be part of the amount realized on sale of the property. Treas. Reg. 1.1001–2(a)(1) (“the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.”)
Notice the phrase “as a result of.” Sometimes taxpayers argue that discharge of a non-recourse debt was not closely enough connected to the sale of the underlying property to make it includable in the amount realized. That’s a tough sell. See e.g. Sands v. Commissioner, T.C. Memo. 1997-146, where the taxpayer transferred ownership of certain property to a lender in one transaction and the lender discharged over $2 million in debt in a separate transaction. Wrote the Court: “we find incredible the contention that [Lender] forgave over $2 million in debt owed by [Taxpayer], while at the same time letting [Taxpayer] retain some ownership rights in the [property], and then in a “separate and distinct” transaction, [Taxpayer] transferred its ownership rights in the [property] to [Third Party, at direction of Lender]. We find that [Lender’s] discharge of the debt and [Taxpayer’s] transfer of its ownership rights were part of a single transaction.”
Thus if the sale of encumbered property involves discharge of the non-recourse debt, then the taxpayer is deemed to have received the full amount of the outstanding debt as a result of the foreclosure. Commissioner v. Tufts, 461 U.S. 300, 317 (1983) (when debtor sells property encumbered by non-recourse debt, the amount realized by the debtor includes the full outstanding balance of the non-recourse debt even if the liabilities exceed the fair market value of the property). Whether that results in income to the taxpayer depends, of course, on basis in the property sold or foreclosed. But what it does mean is that even though there is not an actual full payment of the debt, there is a deemed full payment of the debt. There is just a single transaction: the sale transaction. There is no DOI.
However, if the debt is recourse, then what the taxpayer uses to pay over to lender is just whatever cash or other consideration the taxpayer actually received on sale of the property. There is no deeming. Treas. Reg. 1.1001–2(a)(2) (“The amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness...”). That means that the unsatisfied part of the loan, if discharged, is DOI income, subject to ordinary rates of taxation and also potentially eligible for exclusion under §108. See Treas. Reg. 1.1001–2(c)(2), Example (8).
Let’s see how this plays out in today’s case.
The issue here stems from Mr. Parker’s business activities, conducted through layers of different disregarded entities. The year at issue is 2012. That year Mr. Parker was the sole shareholder of Exterra Realty Partners, LLC (Exterra). In turn, Exterra was sole member of a bunch of Delaware LLCs that were all involved in the acquisition and commercial development of realty. In 2007 those various LLCs had obtained a series of loans from an unrelated lender (Lender) to buy and develop land in Livermore, California. The loans appear to have totaled about $33 million. Mr. Parker signed a personal guarantee for all the loans.
Apparently things did not go well. Remember, the purchase was in 2007, just before the Great Recession depressed us all. Eventually, Exterra decided to cut its losses. Judge Nega writes that “on October 4, 2012, Exterra entered into an agreement to sell the Livermore property to a pair of unrelated individual third-party purchasers (Buyers).” Op. at 3. Because there were a variety of different entities involved, there were a bunch of different agreements that needed to be executed to effectuate the sale. Judge Nega explains it all. But the gist of it was that the Buyers bought the property by assuming responsibility for some of the now ballooned debt (about $40.6 million), relieving Mr. Parker of his personal guarantee, and the Lender agreed to discharge the rest of the outstanding debt (about $12.7 million).
In its initial return, Exterra included all the assumed and discharged debt in its calculation of its business gross receipts for the year. That was the right way to do it. By including the discharged debt in the amount realized, and after accounting for cost of goods sold and appropriate deductions, it reported $2.7 of business income, which flowed into the Parkers’ 2012 return.
However, Exterra later amended its return to exclude that $2.7 as being discharged debt excluded under §108 because Exterra was insolvent by that amount as of the date of the discharge. Again, that treatment passed through and the Parkers likewise filed an amended return reflecting that change.
The IRS audited the Parkers and determined a deficiency, most of which was due to the claim of DOI and §108 exclusion. The Parkers petitioned the Tax Court. Judge Urda explains why doing so gave the Tax Court the power to review both the Parkers’ return and also the flowed-through items reported on Exterra’s return.
The key item here was Exterra’s treatment of the discharged debt. Let’s learn our lesson.
Lesson: Discharge of Non-Recourse Must Be Accounted For As Part of Sale
In Tax Court the taxpayers first focused their arguments on why they were insolvent.
Secondarily they seemed to argue that while the loans may have been non-recourse as to Exterra, they were recourse as to Mr. Parker because of his guarantees. I’m not sure about that last bit but I infer it from this comment by Judge Nega:“As best we can tell, much of petitioners’ briefing is premised on a misconception that facts relating to Mr. Parker in his personal capacity are relevant to the question of whether there was income to Exterra in 2012 (and only then, flowthrough income to Mr. Parker as its 100% S corporation shareholder).” Op. at 9.
But these arguments were putting the cart before the horse. The problem for the Parkers, as you see from the above quote, was that Exterra was the debtor on the loan. Just because S Corps are disregarded for income tax liability purposes does not mean they are otherwise disregarded. To the contrary, Judge Nega reminds us that “we respect Exterra’s separate corporate existence,” Op. at 9, citing strings of cases for the proposition that income earned by an S corporation through its trade or business is not earned directly by its shareholders; the shareholders are responsible only for the flow-through.
There was no question that, as to Exterra, the debt was non-recourse. The only remaining question was whether the discharged debt was “as a result of” the sale of the Livermore property. As I have mentioned, it is difficult for taxpayers to show that non-recourse debt is not connected to the disposition of the underlying property. Today’s case is no exception. There were a bevy of different documents signed and exchanged to effectuate the deal, so it appears that no single document linked the discharge to the sale. But after reviewing the facts and stipulations Judge Nega had no difficulty concluding that “The COD was part and parcel of the global agreement to convey the Livermore property, with [Lender] accepting new personal guaranties, a partial payment by the Buyers, and the escrowed deed to the Iowa property in consideration of that cancellation.” Op. at 10.
Bottom Line: Discharge of non-recourse debt as a result of a property sale cannot generate DOI income (and thus cannot qualify for exclusion under §108) but must instead be used in calculating gain from the sale.
Coda: I highly recommend reading Justice O’Connor’s concurrence in Tufts because she explains why, logically, the sale of underwater property that results in discharge of the non-recourse debt should always be treated as two transactions, not one, regardless of whether the discharged debt is recourse or non-recourse. She goes on to explain, however, that because our legal system is path-dependent (e.g. it relies on precedent), the Tufts Court was constrained by that precedent.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.
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