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taxnotes federalVolume 170, Number 1 ■ January 4, 2021

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Real Estate Partnership Distressed Debt Workouts

by Jack J. Miles

Reprinted from Tax Notes Federal, January 4, 2021, p. 53

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TAX NOTES FEDERAL, VOLUME 170, JANUARY 4, 2021 53

tax notes federalTAX PRACTICE

Real Estate Partnership Distressed Debt Workouts

by Jack J. Miles

The COVID-19 pandemic is having a profound effect on commercial real estate. This article discusses selected federal tax issues arising in connection with real estate partnership distressed debt workouts. The issues arise in connection with:

• foreclosures and deeds in lieu of foreclosure;• debt-for-debt exchanges; and• modifications of a debt instrument.

I. COD Income vs. Section 1001 Gain

Section 61(a) provides that gross income includes gains derived from dealings in property under section 61(a)(3) and income from cancellation of indebtedness (COD) under section 61(a)(12).

If a debtor transfers property to its creditor in satisfaction of debt, the debtor would either realize gain from the sale of property under section 10011 or COD income. The tax treatment will depend on whether the debt is classified as “nonrecourse” or “recourse” for section 1001 purposes.

If the debt is considered nonrecourse, the debtor would realize section 1001 gain, not COD income. For property encumbered by nonrecourse debt, the amount realized on disposition includes the entire principal amount of the debt, even if it is in excess of the fair market value of the property. Section 7701(g) provides that, in determining the amount of gain or loss for any property, the FMV of property is treated as not less than the amount of any nonrecourse debt to which the property is subject.2 This rule also applies if property is transferred in connection with a foreclosure or a deed in lieu of foreclosure, which is treated as a sale for tax purposes.

By contrast, if a debtor transfers to its creditor property encumbered by a recourse debt, the transaction is bifurcated into an amount realized on sale under section 1001, and an amount of COD income. Taxable gain would be realized under section 1001 to the extent that the FMV of the property exceeds the debtor’s tax basis, and, subject to the exclusions described later, COD income would be realized to the extent that the principal amount of the debt exceeds the FMV of the property.3

Assume, for example, that a debtor transfers an asset with an FMV of $1 million in discharge of its $2 million recourse debt, and the debtor’s tax basis in the asset is $300,000. Subject to the COD exclusions described later, the debtor would realize $1 million of COD income ($2 million less $1 million), and $700,000 of section 1001 gain ($1 million less $300,000).

Although the section 1001 regulations do not define the terms “nonrecourse” and “recourse” debt, it is generally believed that a loan is recourse

Jack J. Miles is a partner with Kelley Drye & Warren LLP.

In this article, Miles explores selected tax issues arising in connection with real estate partnership distressed debt workouts, including the circumstances that trigger cancellation of indebtedness income.

1This article assumes that the section 1001 sale would give rise to

taxable gain, not loss.

2See also Commissioner v. Tufts, 461 U.S. 300, 312 (1983), and reg.

section 1.1001-2(c), Example 7.3See Rev. Rul. 90-16, 1990-1 C.B. 12, and reg. section 1.1001-2(c),

Example 8.

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TAX PRACTICE

54 TAX NOTES FEDERAL, VOLUME 170, JANUARY 4, 2021

if the borrower is personally liable for the debt, and nonrecourse if the borrower is not personally liable for the debt and the creditor’s recourse is limited to the collateral.

Query the status of debt incurred by a partnership if debt is recourse to all assets of the partnership, but none of the partners are personally liable for the debt. Regulations promulgated under section 752 do not determine if debt is nonrecourse or recourse for section 1001 purposes.4 It is possible that the classification of partnership debt as nonrecourse or recourse for section 1001 purposes could differ depending on whether the partnership owns only assets acquired with proceeds of the debt.

In some cases, a debtor will have incentives to structure a distressed debt workout to generate section 1001 gain, rather than COD income, because, except to the extent of depreciation recapture, the section 1001 gain could be taxable at preferential capital gains rates, while COD income would be taxable at ordinary income rates. In other cases, a debtor will have incentives to structure a distressed debt workout to generate COD income, rather than section 1001 gain, because, as discussed later, COD income can sometimes be excluded from gross income. Partners may have conflicting objectives. Some partners may prefer COD income, while other partners may prefer section 1001 gain.

A debtor may attempt to convert a recourse debt to a nonrecourse debt or vice versa to minimize tax liability, but it is uncertain whether a tax-motivated change in classification of debt for section 1001 purposes would be respected by the IRS or the courts.

Although a transfer of property subject to a nonrecourse debt gives rise to section 1001 gain, a reduction in the principal amount of nonrecourse debt without a transfer of the collateral gives rise to COD income, subject to the exclusions described later, not section 1001 gain.5 In Briarpark, an insolvent partnership agreed to sell its only asset, an office building, for an amount that was less than the nonrecourse debt balance. The lender agreed to cancel the debt if the borrower

assigned over all the sales proceeds. The Fifth Circuit and the Tax Court rejected the borrower’s argument that it realized COD income, and held that the debt cancellation and sale were too interrelated, thus resulting in section 1001 gain.

It would appear that, theoretically at least, it may be possible to trigger COD income, rather than section 1001 gain, by reducing the principal amount of nonrecourse debt, without tying it too closely to a subsequent sale of the collateral.

II. COD Income Exclusions

A. Bankruptcy and Insolvency Exclusions

COD income is excluded from gross income if (1) the debt discharge occurs in a title 11 case, or (2) the taxpayer is insolvent, but only to the extent the taxpayer is insolvent.6

If the debtor is an entity classified as a partnership for federal tax purposes, the bankruptcy and insolvency COD exclusions apply at the partner, rather than the partnership, level. Thus, if a partnership is insolvent or subject to a title 11 case but a partner is solvent and not subject to a title 11 case, the bankruptcy and insolvency COD exclusions would not apply7 regarding that partner.8

Section 108(d)(3) defines insolvent as the excess of liabilities over the FMV of assets. Insolvency is determined based on the taxpayer’s assets and liabilities immediately before the debt discharge.

In Rev. Rul. 92-53, 1992-2 C.B. 48, the IRS ruled that the amount by which a nonrecourse debt exceeds the FMV of property securing the debt (excess nonrecourse debt) is taken into account for purposes of measuring insolvency only to the extent that the excess nonrecourse debt is discharged.

B. Reduction of Tax Attributes

A taxpayer that excludes COD income from gross income in accordance with the bankruptcy

4See ILM 201525010.

5Briarpark Ltd. v. Commissioner, 163 F.3d 313 (5th Cir. 1999).

6Section 108(a)(1)(A) and (B).

7Section 108(d)(6).

8If the borrower is a C or S corporation, the bankruptcy and

insolvency exceptions apply at the corporate, rather than the shareholder, level.




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or insolvency exceptions is required to reduce its tax attributes by the amount of excluded COD income in the following order: (1) net operating losses; (2) general business credits; (3) minimum tax credits; (4) capital loss carryovers; (5) tax basis in property; (6) passive activity loss and credit carryovers; and (7) foreign tax credit carryovers.9

If COD income is excluded from gross income under the bankruptcy or insolvency exception, then any basis reduction will not exceed the excess of the aggregate adjusted bases of property and the amount of money held by the taxpayer over the principal amount of the taxpayer’s liabilities. To the extent that excluded COD income exceeds the taxpayer’s tax attributes, the COD exclusion will not trigger tax attribute reduction.

An insolvent or bankrupt debtor may elect to reduce the basis of its depreciable property, in lieu of reducing other tax attributes.10 This election may enable a taxpayer to avoid a reduction in NOLs, which could be more valuable to the taxpayer than its tax basis in assets. If this election is made, the tax basis reduction may not exceed the taxpayer’s aggregate bases in depreciable property as of the beginning of the tax year following the tax year in which the discharge occurs.

C. Qualified Real Property Business Indebtedness

For a taxpayer other than a C corporation, COD income can be excluded from gross income if the debt discharged is qualified real property business indebtedness.11

Qualified real property business indebtedness is defined as indebtedness that (1) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by that property, (2) was incurred or assumed before January 1, 1993, or if incurred or assumed after that date, is incurred or assumed to acquire, construct, reconstruct, or substantially improve that property, and (3) for which the taxpayer makes an election.12

COD income excluded from gross income under this exception cannot exceed the excess, if any, of (1) the outstanding principal of the qualified real property business indebtedness immediately before the discharge over (2) the net FMV of the real property immediately before the discharge.13

Under a second limitation, the amount of COD income excluded from gross income for qualified real property business indebtedness cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the debt discharge (other than depreciable property acquired in contemplation of the debt discharge).14

A partner’s interest in a partnership may constitute depreciable property to the extent of the partner’s share of the partnership’s depreciable property if the partnership agrees to reduce its inside basis in depreciable property with respect to the electing partner.15

The determination of whether debt constitutes qualified real property business indebtedness is made at the partnership level, but the COD exclusion election is made at the partner level.16

In some cases, debt is secured by a borrower’s ownership interest in a disregarded entity holding real property. In Rev. Proc. 2014-20, 2014-9 IRB 614, the IRS stated that, under a safe harbor, it would treat debt as “secured by” real property for purposes of determining whether the debt constitutes qualified real property business indebtedness if:

• the taxpayer or a wholly owned disregarded entity of the taxpayer (“borrower”) incurs the debt;

• the borrower directly or indirectly owns 100 percent of the equity in a disregarded entity that owns the real property (the “property owner”);

• the borrower pledges to the lender a first-priority security interest in the borrower’s ownership interest in the property owner;

9Section 108(b).

10Section 108(b)(5).

11Section 108(a)(1)(d).

12Section 108(c)(3).

13Section 108(c)(2)(a).

14Section 108(c)(2)(b).

15Section 1017(b)(3)(C) and reg. section 1.1017-1(g)(2)(i).

16Section 108(d)(6).




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• at least 90 percent of the FMV of assets owned by the property owner must be real property used in a trade or business; and

• upon default and foreclosure on the debt, the lender will replace the borrower as the sole member of the property owner.

D. Purchase Money Debt Reduction

If the debt of a purchaser of property to the seller of that property that arose from the purchase of the property is reduced, the debt reduction could then be treated as a nontaxable purchase price adjustment, which would not give rise to COD income.17 This COD exclusion is not available, however, if (1) the debtor is bankrupt or insolvent,18 (2) the original seller of the property assigned the debt, or (3) the debtor transferred the purchased property.

E. Acquisition of Debt by a Third Party

In some cases, a debtor may attempt to avoid COD income by having a “friendly” third party acquire its debt at a discount. If the purchaser is related to the debtor, as defined for purposes of section 108(e)(4), the acquisition would trigger COD income to the debtor, subject to the exclusions described earlier.

The purchaser and debtor would be deemed related for section 108(e)(4) purposes if (1) they are related under section 267(b) or 707(b) (after applying slightly modified family attribution rules), or (2) they are deemed a single employer under section 414(b) or (c).

If the purchaser acquires the discounted debt in anticipation of becoming related to the debtor, the acquisition of the discounted debt would also trigger COD income to the debtor, subject to the exclusions described earlier. If the purchaser becomes related to the debtor less than six months after purchase, the purchaser is presumed to have acquired the debt in anticipation of being related to the debtor.19 If the purchaser becomes related to

the debtor within six to 24 months after purchasing the discounted debt, it may also be treated as having acquired the debt in anticipation of being related to the debtor, and the purchaser would be required to attach a disclosure statement to its tax return.20 If the purchaser fails to do so, it will be presumed to have purchased the debt in anticipation of becoming related to the debtor. This presumption may, however, be rebutted.

III. Debt-for-Debt Exchanges; Publicly Traded Debt

Under section 108(e)(10), in a debt-for-debt exchange, COD income is computed as if the debtor discharged its existing debt with an amount of money equal to the issue price of the new debt instrument.

Thus, a debt-for-debt exchange will generally give rise to COD income if the issue price of the new debt instrument, as determined under sections 1273 and 1274, is less than the adjusted issue price of the old debt, even if there is no reduction in the stated principal amount of the debt.

Under section 1273(a)(4), for a publicly traded debt instrument, the issue price is equal to the FMV of the debt as of the issue date.

Treasury regulations finalized in 2012 greatly expanded the category of publicly traded debt. Under reg. section 1.1273-(2)(f), debt will be treated as publicly traded if (1) the outstanding stated principal amount of the issue that includes the debt instrument exceeds $100 million, and (2) the debt is traded on an established market during the 31-day period ending 15 days after the issue date. An established market does not have to be a formal market. It is sufficient if there are one or more firm quotes or indicative quotes for that debt. Reg. section 1.1275-3(f)(4) broadly defines the term “indicative quotes” as follows:

An indicative quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) for property and the price quote is not a firm quote.

17Section 108(e)(5).

18In Rev. Proc. 92-92, 1992-2 C.B. 505, the IRS stated that, for a

partnership that is bankrupt or insolvent, the IRS will not challenge the partnership’s treatment of a debt reduction as a purchase price adjustment if the transaction would qualify as a purchase price adjustment but for the bankruptcy or insolvency of the partnership.

19Reg. section 1.108-2(c)(3).

20Reg. section 1.108-2(c)(4).




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Thus, assume that a debtor has debt outstanding with a stated principal amount and an adjusted issue price of $120 million, and it issues a new debt instrument with a stated principal amount of $120 million and an FMV of $70 million (reflecting the debtor’s distressed financial condition) in exchange for its old debt.

If the debt is classified as publicly traded, the debtor would realize COD income in the amount of $50 million ($120 million less $70 million) — because the issue price of the new debt instrument would reflect its $70 million FMV as of the issue date.

By contrast, if the old and new debt are not classified as publicly traded, the debtor would not realize COD income — because the issue price of the new debt instrument would reflect its $120 million stated principal amount, if the interest rate on the new debt instrument is at least equal to the applicable federal rate (AFR).21

If the stated principal amount of debt exceeds $100 million, it will often be difficult for a tax adviser to conclude that the debt is not publicly traded, because to reach this conclusion, the tax adviser would have to determine that no securities sales or pricing services are providing firm quotes or indicative quotes regarding the debt. Further, even if there is no public trading of the debt as of the issue date, the debt could nevertheless constitute publicly traded debt if there is public trading within the 15-day period after the issue date.

A. Original Issue Discount

If a debt-for-debt exchange triggers COD income, it would generally give rise to original issue discount as well, in which case, the creditor would be required to include OID in gross income as it accrues over the term of the new debt, using the constant yield method, and before receiving cash payments.

B. Doubtful Collectibility Exception

Under a doubtful collectibility exception, an accrual basis taxpayer is not required to accrue interest on a debt instrument issued by a financially distressed borrower if the income is of

doubtful collectibility or it is reasonably certain that it will not be collected.22 In LTR 9538007, the IRS held that the doubtful collectibility exception does not apply to an OID obligation. Thus, if a debt-for-debt exchange triggers OID, a creditor may be required to accrue interest on the OID, even if the income is of doubtful collectibility or it is reasonably certain that it will not be collected. Note, however, that the IRS’s position is potentially subject to attack.

C. Applicable High-Yield Debt Obligation

If the debt-for-debt exchange triggers OID and one or more of the partners in the debtor partnership is a corporation, a portion of the partnership interest deduction for the OID could then be deferred or disallowed as a result of the applicable high-yield debt obligation (AHYDO) rules.

An AHYDO is a corporate debt instrument that (1) has a term in excess of five years, (2) has a yield-to-maturity exceeding the AFR plus 5 percentage points, and (3) has significant OID.23 A debt instrument is treated as having significant OID if, as of the end of the first accrual period following the fifth anniversary of issuance, an amount greater than one year’s worth of OID can remain unpaid.24

Under the AHYDO rules, no deduction is allowed for the disqualified portion of OID, which generally reflects yield in excess of 6 percentage points above AFR.25 The balance of OID is allowed as a deduction, but only when and as paid.26

Reg. section 1.701-2(f), Example 1, treats a partnership as an aggregate of its partners for purposes of applying the AHYDO rules to a debt instrument issued by a partnership. Thus, if a partnership has corporate and noncorporate partners, the AHYDO rules could limit or

21See sections 1273(b)(4) and 1274(a).

22See Corn Exchange Bank v. United States, 37 F.2d 34 (2d Cir. 1930).

23Section 163(i)(1).

24Section 163(i)(2). The AHYDO rules can be avoided by including an

AHYDO “catch-up” clause, which requires (1) all accrued and unpaid OID (in excess of OID for one year) to be paid on the first interest payment date following the fifth anniversary of issuance, and (2) all interest to be paid on a current basis thereafter.

25Section 163(e)(5)(A)(i).

26Section 163(e)(5)(A)(ii).




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disallow the interest deduction, but only for the corporate partners.

IV. Significant Modification of Debt

Under reg. section 1.1001-3, a significant modification of a debt instrument generally results in a deemed taxable exchange of the old debt instrument for a new modified debt instrument. Reg. section 1.1001-3(e)(1) states that, subject to some exceptions, “a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.”

A significant modification occurs if there is a change in the yield of a debt instrument by more than the greater of (1) 25 basis points,27 or (2) 5 percent of the annual yield of the original debt instrument.

A modification that changes the timing of payments is also deemed a significant modification if it results in the material deferral of payments. Deferral of one or more payments is not deemed material if the deferred payments are unconditionally payable not later than at the end of an applicable safe harbor period. The safe harbor begins on the original due date that is deferred and extends for a period equal to the lesser of five years or 50 percent of the original term of the debt instrument.

The substitution of a new obligor for a nonrecourse debt instrument is not a significant modification. The substitution of a new obligor for a recourse obligation is generally a significant modification (unless the new obligor is an acquiring corporation in a section 381(a) transaction, the new obligor acquires substantially all the assets of the obligor, or the change in the obligor arises as a result of a bankruptcy or a section 338 election).28

A significant modification of a publicly traded debt instrument with a stated principal amount in excess of $100 million could trigger COD and OID, in an amount equal to the excess of (1) the principal amount of the debt instrument over (2) the FMV of the debt instrument as of the date it is

significantly modified, even if the principal amount of the debt instrument has not changed.

A significant modification of a debt instrument that is not publicly traded should generally not trigger COD and OID, if the interest rate on the new debt instrument is at least equal to the AFR.

If a significant modification of a debt instrument triggers OID, the newly issued debt could then be classified as an AHYDO instrument, even if it was deemed issued in exchange for a non-AHYDO instrument.

A significant modification of a market discount bond could trigger phantom gain to the bond purchaser, based on the excess of (1) the stated principal amount of the bond over (2) the bond purchaser’s tax basis, assuming the bond is not classified as publicly traded debt. Reg. section 1.1001-1(g)(1) provides that if a debt instrument is issued in exchange for property, the amount realized is the issue price of the debt instrument, as determined under reg. sections 1.1273-2 or 1.1274-2.29

A. Sections 108(i) and 163(e)(5)(F)

Responding to the subprime global economic crisis in 2009, Congress enacted section 108(i), which temporarily allowed businesses to defer COD income in specified cases.

Section 108(i) generally allowed a taxpayer to defer COD income in connection with a reacquisition of a debt instrument in 2009 or 2010. The deferred COD income had to be included in income ratably over a five-year period starting in 2014.

Congress simultaneously enacted section 163(e)(5)(F)(i), which provided that a debt instrument issued between September 1, 2008, and December 31, 2009, would not be classified as an AHYDO instrument if it was issued in exchange for a non-AHYDO instrument.

Under section 163(e)(5)(F)(iii), the secretary is authorized to extend this temporary limited suspension of specified AHYDO rules to periods after December 31, 2009, if it is “appropriate in

27Reg. section 1.1001-3(e)(2)(ii).

28Reg. section 1.1001-3(e)(4).

29The gain could be reported under the installment method if the

bond purchaser is not a dealer, but an interest charge for the deferred tax liability may be payable under section 453A.




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light of distressed conditions in the debt capital markets.”

Thus, although legislation would be required to defer COD income using a method similar to section 108(i), Treasury and the IRS already have authority to provide that, in a debt-for-debt exchange or a deemed exchange arising as a result of a “significant modification” of a debt instrument, an instrument should not be classified as an AHYDO if it was issued or deemed issued in exchange for a non-AHYDO instrument.

It is uncertain whether the pandemic and weakness in the economy will give rise to temporary changes in the tax law in this area.




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