Treasury recently finalized regulations clarifying the application of the bankruptcy and insolvency exceptions to cancellation of debt income involving a debtor partnership with one or more partners that are disregarded for income tax purposes. Section 108(a)(1)(A) and (B) exclude cancellation of debt from income if the cancellation or discharge occurred in a bankruptcy case or to the extent the taxpayer is insolvent. Where the debtor is a tax partnership, these exceptions are applied at the partner level instead of at the partnership level. Where a partner is a disregarded entity or grantor trust, the final regulations clarify that the bankruptcy and insolvency exceptions are applied by looking through the disregarded entity or grantor trust to the ultimate owner for income tax purposes. Consequently, the insolvency analysis is applied to the ultimate owner of the disregarded entity or grantor trust, and not to the disregarded entity or grantor trust itself. Similarly, in order for the bankruptcy exception to apply, the ultimate owner of the disregarded entity or grantor trust must be subject to a bankruptcy court’s jurisdiction.
When a lender discharges debt for less than full consideration, the borrower by default recognizes income for federal income tax purposes. “Qualifying Real Property Indebtedness” is an exception. Forgiveness of Qualifying Real Property Indebtedness may be excluded from income. New IRS guidance expands this exclusion.
The Qualifying Real Property Indebtedness exclusion generally applies to debt secured by real property, if a taxpayer incurred the debt in connection with a business using the property. The IRS guidance clarifies that “secured” debt is not limited to a traditional real estate mortgage. A debt secured by the membership interest in a “disregarded entity” limited liability company that owns real estate may qualify, even though the lien does not attach directly to the real estate.
IRS targeted the guidance at a specific mezzanine loan structure, but taxpayers in other structures may utilize the exclusion as well. Other notable cancellation of indebtedness income exclusion opportunities include: taxpayer insolvency, debt forgiven in certain bankruptcy proceedings, and seller-financed debt forgiven as a purchase price adjustment.