Do partners owe tax when their real estate partnership’s debt is cancelled in bankruptcy?

You got an enormous loan to develop commercial real estate, defaulted, and the lender wrote part of it off. You know someone owes tax on that, but who? The partnership? You? The short answer is often you, the partner, unless you are bankrupt or insolvent. The Tax Court once let partners who had never filed use the bankruptcy of the partnership, but the IRS refuses to follow that. About $1 trillion in commercial real estate loans were due to mature in 2024. Many were unlikely to be repaid. Forgiven debt generally creates cancellation of debt income (CODI). But bankruptcy or insolvency can be an exception, this is tested partner by partner, not partnership by partnership. It is not a tax freebie. Using this exception reduces other tax attributes including basis, loss or credit carryovers. Complicated when doing so in bankruptcy.

Money a business borrows isn’t considered income, but if it’s forgiven, it becomes taxable as canceled debt income, or CODI, unless one of the exceptions to the rule applies. It’s borrowed; it’s not a gift. The Supreme Court decided the Kirby Lumber case in 1931. Now it’s in the tax code, at IRC 61(a)(11). Kirby bought back some of its own bonds for less than the face amount due. The Supreme Court ruled that the difference in price had to be counted as income because the loan was canceled or forgiven. Today, if a lender settles a loan for less than the borrower owes, the borrower has cancellation of debt income. Treas. Reg. 1.61-12.

Not every cancelled debt is taxable. There are exceptions in IRC 108(a)(1). Debt cancelled in bankruptcy or while the taxpayer is insolvent is one such.

If your business is a partnership (or an LLC taxed as a partnership), it doesn’t pay income tax. Instead, the CODI passes through to the partners who pay tax on it, in their personal returns, based on the distributive share they each own, unless the partnership agreement says something different and unless the change made by the agreement has no substantial economic effect on the partners or the partnership. When the lender cuts the debt, each partner gets canceled debt income to report, depending on their distributive share of the partnership. The partners are responsible for the tax even if they never get any cash or property from the partnership as part of the cancellation.

Your share of partnership CODI is an adjustment, increasing the basis of your partnership interest under IRC 705(a). Basis is your tax investment. Basis adjustment means you have a smaller gain, or a larger loss on a sale. That’s good.

But cancelling the debt also lowers each partner’s share of partnership liabilities, which are treated as cash distributed to them under IRC 752(b). Every partner will have a lower basis in the partnership interest (IRC 733). So this means the partner has more gain, or less loss, when the interest is sold.

It’s a tricky situation if a partner is deemed to have taken the distribution. If the amount of the deemed distribution is greater than the partner’s adjusted basis, then the partner has taxable gain equal to the excess. The gain is reported on the partner’s tax return. Even if no cash or property is actually distributed by the partnership, that partner is on the hook for the tax.

The basis increase of the partner’s interest because of the partner’s share of partnership CODI is reduced by the amount of the deemed distribution of cash to the partner. If their bases are lower than the amount of deemed distribution, they may have taxable gain under IRC 731(a).

Tax Attributes Are Reduced

You might have guessed there was a price for this opportunity to avoid tax on income that was cancelled. There is. Once a taxpayer chooses to use the special insolvency or bankruptcy exception for CODI, dollar for dollar the tax benefits of other losses, credits, and tax attributes are reduced. IRC 108(b) has an ordering rule. It lists which tax attributes are reduced first, for the amount of cancelled debt. It starts with NOLs, then business and minimum tax credits, capital loss carryovers, basis and passive activity carryovers, with foreign tax credits last. Usually, it’s only a deferral of tax, not total escape. In some bankruptcy fact patterns the tax on cancelled debt may be avoided permanently.

The exceptions to the rule of taxing forgiven debt are under IRC 108(a)(1).

Discharged debt (whole or partial) of taxpayer’s indebtedness in (A) a title 11 case, or (B) when the taxpayer is insolvent is excluded from gross income. (Title 11 is bankruptcy law.)

Indebtedness of the taxpayer is, generally, any debt for which the taxpayer is liable, or subject to which the taxpayer holds property. (IRC 108(d)(1).)

A title 11 case is a bankruptcy case. It counts only if the taxpayer is under court jurisdiction, and any discharge is granted by the court or under a plan approved by the court. IRC 108(d)(2). Just filing bankruptcy is not enough: You have to be in a title 11 case and have the debt discharged by the court, or in a plan the court approves.

Partnerships get a rule of their own in IRC 108(d)(6). The exception for discharge or cancellation of debt is applied to each member of the partnership and not to the partnership, i.e., partner by partner and not partnership by partnership.

So it seems only the partners who are insolvent or bankrupt are relieved. Partners themselves in bankruptcy or insolvency can be excused from the income of cancelled debt, but the partnership’s status doesn’t help solvent partners. So if you are solvent, never filed and the partnership declared bankruptcy, you may not be able to avoid CODI on your share. It’s not one for all and all for one.

Relying on Gracia or on the IRS’s View

The Tax Court decided 4 Gracia Cases (TC Memo 2004-147 to 150). Notchcliff Associates partnership was in Maryland bankruptcy in 1988. The partnership had more than $20 million dollars bank debt guaranteed by the partners. Part of that was cancelled. Here, the debt cancellation appears to have created a CODI of at least $2.8 million. The partners executed contribution agreements for a total of $250,000, with the bankruptcy court-approved plan releasing them from claims related to the partnership. The Tax Court held that the partners could use the bankruptcy exception even though none of the partners was in bankruptcy. It reasoned that, by discharging the partnership debts, the court had exercised jurisdiction over them.

The IRS doesn’t agree. They didn’t just disagree in words, they disagreed by issuing Actions on Decisions in 2015 against all four of the cases (not just one). That means the IRS isn’t going to follow the Tax Court’s decision.

And they say it doesn’t work that way because it’s contrary to the structure of the tax code section and the intent of Congress to provide a fresh start for the bankrupt debtor. The IRS says the bankruptcy exception applies only where the partner is in bankruptcy, not for the partnership who files bankruptcy.

The first one, AOD 2015-01, 2015-6 IRB 579, says the IRS nonacquiesces, taking from language in an older Tax Court decision, Yamamoto (TC Memo 1990-549, affirmed on other grounds by the Ninth Circuit in 1992).

In Yamamoto, the Court said plainly that Sec. 108 and its legislative history (Senate Report 96-1035) clearly indicate that its relief is extended to the debtor in bankruptcy, not those who owe the debtor money. There, the debtor was MFC, a lending company indirectly owned by Yamamoto; Yamamoto owed the money to MFC.

The 2016 Treasury regulation 1.108-9 follows the IRS view of this and cites the AODs as authority for them. For a grantor trust and disregarded entities, the owner must be the debtor (11 U.S.C. 101(13)). The grantor of the trust and the sole member of the LLC, for example, needs to be the debtor in bankruptcy.

The preamble to the final regulations says that, if the partnership owns such an entity, a partner must itself be the debtor under court jurisdiction in its own title 11 case to apply the exception. It has to be the partner in its own bankruptcy.

(T.D. 9771, 81 Fed. Reg. 37,504, June 10, 2016.)

A partnership does not pay income tax, yet through the presumption of CODI, any of the partners in the partnership may have to write a check to the IRS under certain situations. I would not look for free money here if I was one of those partners. Treat the cancellation of debt income situation by situation, but keep in mind that no situation of CODI is simple, especially with real estate collateral that is distressed. Many things to consider here, and too complex to cover thoroughly. Your own basis; the deemed distribution; are you yourself insolvent or in bankruptcy; and whether you would be relying on Gracia or on the IRS’s view.

A note on words: here, cancellation, discharge, forgiven, all mean the same thing.

In Kirby Lumber, a Supreme Court case from 1931, a company bought its own bonds back for less than face value and was told it had income from cancelling the debt it owed. Kirby Lumber, 284 U.S. 1 (1931). The Court (Justice Holmes) decided that the discount was taxable income.