A lot of us know that if you borrow money and the debt is later cancelled, it triggers taxable income known as "cancellation of debt", or "COD," income. Section 108 of the Internal Revenue Code provides ways to reduce or eliminate COD income - for example, by showing you're insolvent. But what surprises many people are the tax results of canceling debt by transferring to the creditor property that secures the debt.
Let's take an example. Say you bought land for $50, and it's now worth $100. You refinance with an $80 loan. In the loan documents, the creditor's rights are limited to the property, so the loan is non-recourse. The property's value later diminishes to $60 and you opt to convey it to the lender in full satisfaction of the debt. In other words, you borrowed $80 and repaid the creditor with property worth $60. Looks and smells like COD income - but it's not! Since the debt was non-recourse, the tax rules recast the transaction as though you sold the property for a purchase price equal to the loan balance ($80). Instead of COD income, you have gain from the sale of property in the amount of $30 ($80 less $50 basis).
What's the big deal? The various ways in Section 108 to reduce or eliminate COD income don't apply to gain from the sale of property. So in our example, you're taxed on the $30 gain even if you're insolvent. There's another big difference: COD income is ordinary, but the $30 gain may be capital gain.
The bottom line is it matters if canceled debt is non-recourse, and it's not always obvious. A recent IRS Chief Counsel advice explained how to determine whether debt is non-recourse when COD income is at stake. CCA 201525010 (2015). The debt at issue was incurred by an LLC and guaranteed by the members. The loan documents weren't clear on whether the debt was recourse or not. The LLC transferred the property to a creditor in satisfaction of debt.
The taxpayers - the LLC's owners - wanted the canceled debt to be recourse because there would be COD income. They were insolvent and hoped to rely on Section 108's elimination of COD income. The IRS wanted the canceled debt to be non-recourse, in which case there would be gain from the sale of property, Section 108 wouldn't apply, and the taxpayers' insolvency wouldn't matter.
The taxpayers argued that because they had guaranteed the debt, it was recourse. After all, the guarantees meant the creditor's rights weren't restricted to the property. The taxpayers relied on the definition of "non-recourse" in the partnership rules that relate to how partnership debt is allocated among partners. See Reg. 1.752-1(a)(1). Under those rules, debt is generally recourse to a partner if it is guaranteed by the partner. But the CCA outright rejected the application of those rules. It said that whether debt is recourse under those rules does not affect the determination of whether it is recourse for purposes of COD income.
The CCA also suggested that the debt under consideration could be non-recourse even though the creditor could recover against all of the LLC's assets. It turned out that the LLC was a special purpose entity, and so the LLC wasn't authorized to acquire assets other than the secured property. But Chief Counsel stopped short of resolving the issue - it said whether debt is non-recourse is a factual issue best handled by the examining agent.
Whether debt is non-recourse can make major tax differences if the debt is canceled. It's a good idea to have those differences in mind at the outset of the loan, and draft documents clearly to obtain the desired results. Otherwise, the IRS most likely will assert the interpretation that results in the highest taxes.