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Partnership - Audit Technique Guide - Chapter 8 - Real Estate Issues in Partnerships (Published 12-2002)

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 7 | Table of Contents | Chapter 9

Chapter 8 - Table of Contents

 

Issue:  Disposition of Property Subject to Non-Recourse Debt and Unpaid Interest        

Issue:  Accrued Contingent Interest      

Issue:  Bankruptcy     

Issue:  Low Income Housing Tax Credit (IRC section 42)   

Issue:  Capturing “Phantom” Gain In Zombie Partnerships   

Issue:  IRC section 263A ─ Uniform Capitalization    

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INTRODUCTION

Approximately 50 percent of all partnerships are involved in the real estate business.  A partnership may be involved in real estate development, construction, or leasing.  Even though a partnership may not be involved in a real estate business it may own or lease real estate.  This chapter covers various tax issues related to real estate such as:

  • Cancellation of Indebtedness
  • Tufts/ Non-recourse Debt and Unpaid Interest
  • Accrued Contingent Interest
  • Bankruptcy
  • Low Income Housing Tax Credit
  • Zombie Partnerships
  • Uniform Capitalization ─ IRC section 263A

The first two issues deal with the determination of whether the reduction of partnership debt should be treated as taxable cancellation of indebtedness income under IRC section 61(a)(12).  Cancellation of indebtedness income may not be taxable due to an exception under IRC section 108, or it may be considered a taxable gain from the sale/exchange of property under IRC section 61(a)(3).  See decision chart (Exhibit 8-1) at the end of this chapter as an audit aid to assist you in making this determination.

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ISSUE:  CANCELLATION OF INDEBTEDNESS ─ IRC SECTIONS 108 AND 1017

When a partnership purchases real estate it normally finances a portion of the purchase price.  Partnerships may refinance or restructure the debt due to financial difficulties, to get a lower interest rate, or borrow more money.  If the partnership refinances or restructures the debt and part or all of the debt is discharged, the partnership will realize cancellation of indebtedness (COD) income.  If a financially troubled partnership’s property is sold at a foreclosure sale or to a third party, the partnership abandons property (such as by quit claim deed or a tax sale), or the partnership reconveys the property to the lender (that is, deed in lieu of foreclosure), it may realize COD income or realize a gain or loss on the disposition, or a combination of both.  This determination will turn on the nature of the debt involved, that is, non-recourse or recourse, see Chapters 3 and 6 for additional information on recourse versus. non-recourse liabilities.

The determination of the existence or amount of COD income and the amount of sale/exchange gain or loss are both made at the partnership level.

If debt is discharged and the payment of the debt would have given the taxpayer a deduction, then the taxpayer does not realize COD income under IRC section 108(e)(2).  For example, when a cash basis taxpayer’s obligation to pay an expense is cancelled.

If seller financed debt is reduced for a solvent taxpayer, the reduction is treated as a purchase price reduction.  It is not considered COD income. IRC section 108 (e)(5).

Each partner’s distributive share of COD income and sale or exchange gain is separately stated on his or her Schedule K-1.

Partners must include COD income in taxable income unless an exception applies (IRC section 61(a)(12)).  The taxability of COD income is determined at the partner level (IRC sections 108(d)(6) and 6231(a)(5)). In addition to the summary report an affected item report must be prepared because additional factual determinations are required at the partner level.

A partner may exclude COD income under IRC section 108 if:

  1. Partner is bankrupt (Title 11 discharge-See sub-chapter B)
  2. Partner is insolvent (limited to level of insolvency)
  3. Qualified farm indebtedness is cancelled
  4. Debt is Qualified Real Property Business Indebtedness (“QRPBI”), the partner is not a C corporation, and the partner elects to reduce basis in depreciable real property.

Note:  If more than one of these exceptions apply, they are applied in the above order.  IRC section 108(a)(2)(A).

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Non-Recourse Debt

Property Dispositions: (that is, Foreclosures, Abandonments, Sales, etc.)

COD income is not realized when property that secures non-recourse debt is disposed/sold (that is, sale, foreclosure, deed-in-lieu of foreclosure, abandonment, etc.).  The non-recourse obligation is considered the amount realized (that is, sales proceeds) (Tufts v. Commissioner, 461 U.S. 300 and IRC section 7701(g)).  It does not matter that the fair market value is equal to or less than the amount of the debt.

Example 8-1

 

Facts:   

Sales Price of Property 

$200,000

Adjusted Basis

50,000

Non-recourse Liability 

300,000

        
Computation of Gain:      

Amount Realized (Non-recourse Debt)

$300,000

Adjusted Basis                                   

(50,000)

Gain on sale/exchange          

$250,000

 

 

 

 

                   

                    
                                     

Property Retained-Debt Reduced

If the debtor retains the property and the creditor reduces non-recourse debt, COD income will be realized (Gershkowitz v. Commissioner, 88 T.C.984 (1987) and Rev. Rul. 91-31)

Example 8-2
 

 

Non-recourse debt before cancellation

$300,000

Non-recourse debt after cancellation       

(200,000)

COD income (IRC section 61(a)(12))

$100,000

 

 

 

Property Sold and Debt Discharged

The following sequence of events are considered part of one overall sales transaction:

  1. Partnership sells a building subject to non-recourse debt to a third party.
  2. The sales proceeds go to the lender.
  3. The lender discharges the difference between the debt and the sales proceeds.
  4. The lender settles a partner’s personal guarantee for a lesser amount.

In this transaction, the amount realized will equal the amount of the non-recourse debt less the amount required to be paid by the guarantor.  (2925 Briarpark, Ltd., TC Memo 1997-298, aff’d 99-1, Par. 50,209, (5th Cir.)

Recourse Debt

Property Dispositions

COD income may be realized when property that is security for recourse debt is disposed/sold.  If recourse debt cancelled is more than the FMV/sales price of the property, the difference is treated as COD income.  If recourse debt is equal or less than the FMV/sales price of the property, no COD income is realized.  The difference between the FMV/sales price and adjusted basis of the property will be treated as gain or loss on sale/disposition of property (IRC section 1001(a)).

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Example 8-3
 

 

Facts: 

     

Partnership owns a building with: 

Computation:

FMV -                    $100 Debt Owed

$200

Recourse Debt -    $200 FMV 

(100)

Adjusted Basis      $ 75 COD Income

$100

                               FMV/Amount 

   

                                 Realized

$100

                                 Adjusted Basis

(75)

                                 Gain-Taxable        

$  25

 

 

 

 

 

 

              
Property Retained-Debt Reduced

If the debtor retains the property and the creditor reduces recourse debt, COD income will be realized.

 Example 8-4
 

 

Recourse debt before cancellation      

$300,000

Recourse debt after cancellation 

(200,000)

COD income (IRC section § 61(a)(12)) 

 $100,000


       
    

 

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Exceptions

Bankruptcy

See Issue D in this chapter.

Insolvency

If a partner is insolvent, then he or she may exclude COD income to the extent insolvent (IRC section 108(a)(1)(B) and IRC section 108(a)(3).  If the cancellation of debt removes a partner from insolvency, the partner must recognize income to the extent made solvent.  That is, to the extent the fair market value of the partner’s assets exceeds his or her liabilities immediately after the cancellation.

Insolvency is determined immediately before discharge of debt (IRC section 108(d)(3)).

The amount by which a non-recourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent, but only to the extent that the excess non-recourse debt is discharged.  Rev. Rul. 92-53.

The fair market value of assets that are exempt under state law are not excludable in determining insolvency.

Contingent liabilities (guarantees) are not included in the insolvency computation.  Merkel, 109 T.C. 463 (1997), aff’d, 99-2 U.S.T.C. Par. 50,848 (9th Cir. 1999).

The burden of proving insolvency is on the taxpayer.  Bressi, T.C. Memo 1991-651.

INSOLVENCY COMPUTATION:

Fair Market Value of Assets (less selling costs)

• Cash
• IRAs/Pensions
• Life insurance (cash surrender value)
• Personal property
• Real property
• Stocks, Bonds, & Other Securities
• Business interests (Partnerships, S-Corporations, LLCs, etc.)
• Accounts/Notes Receivable

Less: Liabilities

• Recourse Debt
• Non-recourse Debt

       = (Insolvency) / Solvency


Tax Attribute Reduction-Insolvent and Bankrupt Partners

If cancelled debt is excluded under IRC section 108 because a partner is bankrupt or insolvent, he or she must use the excluded amount to reduce net operating losses, capital losses, basis, suspended passive losses, and other tax attributes.

Qualified Farm Indebtedness

Must be done by a “Qualified Person” and the taxpayer must have sufficient tax attributes (IRC section 108(g)).

Qualified Real Property Business Indebtedness

Solvent partners, other than C corporations, may exclude cancellation of Qualified Real Property Business Indebtedness (“QRPBI”) income if certain requirements are met (IRC section 108(c)).

  • The determination of whether cancelled debt is QRPBI is made at the partnership level. The debt cancelled must be secured by real property used in the trade or business and incurred before January 1, 1993, or be Qualified Acquisition Indebtedness.
  • The excluded COD income cannot exceed the partner’s share of the difference between the outstanding principal amount of debt (before discharge) and the fair market value of the real property (reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property); and the partner’s total adjusted bases of depreciable real property.  The outstanding principal amount includes prior year accumulated accrued and unpaid interest (Final Treas. Reg. section 1.108-6(a)).

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 Example 8-5

Partnership owns a building subject to $1.5 million non-recourse debt.  Partnership had difficulty making loan payments.  Lender agreed to accept $1 million in full satisfaction of the debt.  Partnership borrowed $1 million from “new” lender to pay off old loan.  “New” lender appraised building at $1.2 million.  Partnership realized COD income of $300,000 ($1.5 million - $1.2 million [Fair Market Value]) that is eligible for the QRPBI exclusion.  Partnership realized taxable COD income of $200,000 ($ 500,000 Total Debt Canceled - $ 300,000 Excludable COD income) that is not eligible for the QRPBI exclusion.

 

Old non-recourse debt  

$1,500,000

“New” debt 

(1,000,000)

Total debt canceled 

$   500,000
         

Old non-recourse debt  

$1,500,000

Fair Market Value 

(1,200,000)

Excludable COD income 

$   300,000

          

Total debt canceled

$ 500,000

Excludable COD income  

(300,000)

Taxable COD income 

$ 200,000

 

 

 

 

 

 

 

   

  • The adjusted basis of qualified real property (whose debt was reduced) must be reduced by discharged QRPBI before the adjusted bases of other depreciable real property are reduced (Final Treas. Reg. section 1.1017-1(c)(1)).
  • The basis of property acquired in contemplation of cancellation of indebtedness may not be reduced.
  • The partner must make a timely election to reduce the bases of his or her depreciable real property (Note:  Depreciable real property does not include land, furniture and fixtures, equipment or intangible assets).  A partnership interest is considered depreciable real property to the extent of the partner’s share of depreciable real property. To make the election, the partner uses Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness in the year COD income is received.  The partner must attach a detailed description, by property, identifying any reduction in basis under IRC section 1017.
  • For the partner’s basis in his or her partnership interest to be reduced the partnership must make a corresponding reduction in the partner’s share of depreciable real property on its books.  If the partnership does not make the reduction, then the partner may not exclude the COD income (See Treas. Reg. section 1.1017-1(g)(2) for general rule and exceptions).
  • The partnership must consent to the reduction of partner’s share of inside basis if-
    1. The partner owns (directly or indirectly) more than 80 percent interest in the capital and profits of the partnership, or
    2. Five or fewer partners own (directly or indirectly) an aggregate of more than 50 percent of the capital and profits interests of the partnership (See Treas. Reg. section 1.1017-1(g)(2)(ii)(C)).

Partnership Consent Statement (Treas. Reg. section 1.1017-1(g)(2)(iii))

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Partnership Requirement:

  • Statement must be attached to partnership return (Form 1065) for the taxable year following the year that ends with or within the taxable year the partner excludes COD income.
  • Statement must be provided to the partner on or before the due date of the partner’s return (including extensions) for the taxable year in which the partner excludes COD income.
  • Statement must contain the following:
    1. Name, address, and taxpayer identification number of the partnership; and
    2. States the amount of the reduction of the partner’s proportionate interest in the adjusted bases of the partnership’s depreciable real property.

Partner Requirement:

  • The partnership consent statement must be attached to the partner’s timely filed (including extensions) tax return for the taxable year in which the partner excludes COD income.
  • If the property whose debt is reduced is sold in the same year as the debt cancellation, IRC section 1017 (a)(3)(F) requires that the basis reductions be effected immediately before the sale.  As a result, basis reductions will be immediately triggered into income (as ordinary income due to IRC section 1245) upon the sale (IRC section 1017(b)(3)(F)(iii)).  This immediate recapture normally will take any tax benefit away from IRC section 108(c).

Example 8-6

In 1998 the partnership restructured its debt and realized COD income of $500,000.  All of the partners elected to reduce the basis of their partnership interests (considered depreciable real property).  On December 30, 1998, the partnership sold all of its real property for $1 million.  Prior to the QRPBI basis reduction the adjusted basis of the partnership’s real property was $500,000 for the building and $100,000 for the land.  The partnership computed its gain on disposition of real property as follows:

 

Sales Price 

     

$1,000,000

Adjusted Basis before
      QRPBI Reduction  

$500,000

   

QRPBI Reduction 

               (500,000)**      
   

 -0-

   

Land  

100,000

   

Adjusted Basis 

   

(100,000) 

Gain on sale/exchange       $   900,000**

     
                                                                                    
       

 

 

 

 

**$500,000 of gain is considered ordinary income (IRC section 1245).  The balance of the gain is IRC section 1231 gain.

Accrued Interest Expense

See sub-chapter B for the treatment of accrued unpaid interest when a property secured by non-recourse debt is sold/foreclosed.  See sub-chapter C for the treatment of accrued unpaid contingent interest.

If debt is cancelled during the year, current year accrued interest is not allowable.  If interest has been accrued during the year and it will never be paid, there is no fact of liability.  The all events test has not been met (IRC section 461(h)(4)).  In addition, IRC section 108(e)(c)(2) says to ignore items that would give rise to a deduction.

The outstanding principal amount of QRPBI includes prior year accumulated accrued unpaid interest expense (Treas. Reg. section 1.108-6(a)).

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Passive Activity Loss Limitations

COD Income Excluded under IRC section 108(a)(1)(A), (B), (C):

Cancelled debt that is not taxed because a taxpayer is bankrupt (Title 11), insolvent, or has qualified farm indebtedness discharged cannot be passive income on Form 8582 (Passive Activity Loss Limitations) line 1a or 2a.  Passive income is only income that is taxed in the current year.  If cancelled debt is taxable income under IRC section 61(a)(12), then it may be passive income.

However, COD income that is excluded under IRC section 108(a)(1)(A), (B), or (C) shall be applied to reduce tax attributes of the taxpayer (IRC section 108(b)).  Passive activity loss and credit carryovers are considered tax attributes.  Tax attributes (including passive activity losses and credits) that are reduced may never be deducted by the taxpayer.

Taxable COD Income (IRC section 61(a)(12) and Gain on Foreclosure or Sale (IRC section 61(a)(3):

Generally taxable COD income is passive to the extent it is allocated to passive activity expenditures at the time the debt is discharged (Rev. Rul. 92-92).  A similar rationale can be applied to gain on foreclosure or sale of property.

There are some exceptions to this general rule.  In the following cases COD income or gain on foreclosure or sale of property should be considered non passive income and should not be on Form 8582 line 1a or 2a:

  • Partner is a real estate professional and materially participated in the partnership rental activity in the year income or gain is recognized. See IRC section 469(c)(7) and Treas. Reg. section 1.469-9.
  • COD Income and/or gain on foreclosure or sale of property is non-passive if the property was leased to an entity where the investor worked (that is, materially participated – the self-rental recharacterization rule).  See Treas. Reg. section 1.469-2(f)(6).
  • COD Income and/or gain on foreclosure or sale of property are non-passive if less than 30 percent of the unadjusted basis is depreciable.  Income from land, whether held for investment or leased or sold, is non-passive.  See IRC section 469(e)(1)(A)(ii)(II) and Treas. Reg. section 1.469-2T(f)(3).
  • In the year of disposition, COD income and/or gain on foreclosure or sale of property is recognized but the partnership is not a rental activity or business.  See Treas. Reg. section 1.469-2T(c)(2)(A)(I)(3).  Whether or not property is rented in the year of disposition is easy to determine.  Simply review Form 8825 for rental income and/or advertising expense.
  • Even if COD income and/or gain on foreclosure or sale of property is determined to be passive, it does not belong on Form 8582, triggering unrelated passive losses, if current and suspended losses from the activity disposed of exceed income/gain reported from the activity. See IRC section 469(g).

IRC section 469(g) permits the deductibility of all current and suspended losses IF there is an entire disposition of a partnership interest in a fully taxable transaction to an unrelated party.  Thus, whether or not the character of income attributable to cancelled debt and/or gain on foreclosure/sale is passive or non passive, all losses (current and suspended) from the partnership will be deductible.  If the amount or timing of COD income and/or gain on foreclosure/sale has yet to be determined, there is not a “fully taxable” disposition (that is, all gain/loss realized and recognized) as required by IRC section 469(g).  Any legitimate passive income will, of course, trigger deductibility of losses.

While Revenue Ruling 92-92 generally provides that COD income from a passive activity in the taxable year of disposition IS passive income, the rules for real estate professionals were enacted beginning in 1994, 2 years later.  If a taxpayer is a real estate professional (spends majority of his time on real property businesses and/or rentals) and he or she materially participates in the rental activity disposed of (performs most of the work or more than anyone else does), income will be non-passive.  See IRC section 469(c)(7) and Treas. Reg. section 1.469-9.  In other words, gain on foreclosure or sale and COD income, while still reportable, may not be used on Form 8582 line 1a or 2a to trigger unrelated passive losses.  Under IRC section 469(f), however, the COD income/gain will trigger losses from the same activity.  Even if the activity is not disposed of and debt related to the activity is cancelled, it will trigger losses from the same activity, but not from unrelated activities.

Example 8-7

Facts:

Taxpayer is a real estate professional and owns multiple real estate rental activities, some of which are partnership interests.  Debt of $2 million is cancelled on one partnership interest.  The partner materially participates currently in the real estate partnership or he materially participated any 5 of the prior 10 years (Treas. Reg. section 1.469-5T(a)(5).

Taxpayer has the following suspended and current year losses:

  • $1 million in suspended passive losses from the partnership interest.
  • $500,000 in current year losses from the partnership interest.
  • $200,000 in suspended passive losses from other real estate rental activities.

Computation:

 

COD Income 

$2,000,000

Partnership-suspended passive losses   

(1,000,000)

Partnership-current year loss 

(500,000)

COD Income-non-passive                            

$   500,000

                                                                                       

 

 

$500,000 of COD income cannot be used to offset unrelated suspended passive losses.

Additional guidance may be found in the MSSP Passive Activity Guide.  You can also contact the Passive Activity Issue Specialist.

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Examination Techniques

The following determinations need to be made during the examination:

  1. Whether the partnership realized COD income.
  2. Whether the partnership correctly reported COD income.
  3. Whether COD income should be recharacterized as gain on disposition of partnership property.
  4. Whether the partnership improperly deducted accrued unpaid interest expense in the year the debt was cancelled.
  5. Whether the partnership deducted accrued unpaid contingent interest expense and/or included it in COD income (see sub-chapter C).
  6. Whether partners correctly report COD income and/or reduced tax attributes.  (Note: Since additional factual determinations are required at the partner level, an affected item report will need to be prepared.)
  7. Scrutinize any depreciable real property acquisitions within 18 months of the receipt of COD income.  Interview the taxpayer and lender to determine whether any substantial discussions regarding restructuring partnership debt were held prior to the acquisition of depreciable real property.  If there were, the basis of recently acquired depreciable real property may not be reduced in lieu of reporting cancelled QRPBI income.
  8. As part of determination of whether debt is recourse or non-recourse, inspect prior year partnership return and Schedules K-1 to see how debt was classified.  Balance sheet of partnership return has a non-recourse debt line.  However, some partnerships may enter non-recourse debt on the mortgage line of the balance sheet, but also reflect it on the Schedule K-1 as Qualified Non-recourse Financing.

Issue Identification

COD and Basis Reduction:

  1. Balance sheet of partnership tax return shows a substantial decrease in liabilities at year-end.  This may indicate cancellation of indebtedness income.  Real estate partnerships will frequently renegotiate mortgages when the value of real property declines.
  2. Other income shown on Schedule K may be COD income.
  3. Instead of showing COD income on the individual partner’s Schedule K-1 there may be a supplemental statement suggesting that the partner consult their tax advisor on how to report the reduction in debt.
  4. Analysis of “old” and “new” loan documents will indicate amount of COD and whether debt is secured by real property.  For a partner to exclude COD income under the QRPBI exception, the debt must be secured by real property and the security must be recorded.
  5. An appraisal will indicate whether the debt cancelled exceeds the difference between the amount of debt and the fair market value of the real property.  The QRPBI exception does not apply to the excess debt cancellation.  Therefore, the excess will be taxable income.
  6. If solvent partners elected to reduce basis in their partnership interests rather than report COD income (QRPBI exception), the partnership tax return for the year subsequent to the debt discharge should be inspected.  The balance sheet of the partnership return should show a decreased basis in real property and the Schedules K-1 should include a statement indicating the amount by which the partners should adjust income for the basis decrease.  If partners elected to reduce basis in other depreciable real property (not owned by the partnership), there would not be a statement on the subsequent year Schedules K-1.
  7. Analysis of interest expense worksheets/schedules will indicate whether the partnership has improperly accrued interest expense in the workout year. Accrued unpaid interest should not be deducted or included in COD income.

COD versus Sale:

  1. If the partnership reports a sale of property and COD income, analyze all loan documents to determine whether loan was non-recourse or recourse.  If the loan is determined to be non-recourse, analyze all sales documents to determine whether there were two transactions or one interrelated transaction.  If it is determined that there was one transaction, then the full amount of non-recourse debt should be treated as sales proceeds.  2925 Briarpark Ltd., TC Memo 1997-298, aff’d 99-1, Par. 50,209, (5th Cir.).
  2. If inspection of the partnership return indicates that COD income was reported, property decreased on the balance sheet, and a loss/very small gain/ or no gain on sale of partnership property was reported, determine whether partnership properly reported transaction.
  3. Analyze all loan and purchase/sales documents.  If a guarantee of non-recourse debt was made at the eleventh hour, it may not change the status of the loan from non-recourse to recourse.  For example, if the guarantee provides that a partner must repay the loan only if he fights the foreclosure sale, this would be considered a contingent guarantee and would not change the loan from non-recourse to recourse.  If you have an 11th hour guarantee issue, call a Partnership Technical Advisor.

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Documents to Request

  1. Partnership Agreement and all amendments.
  2. Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees and/or loan indemnification agreements.
  3. If the loan has been restructured, provide all documents relating to the amended and restated loans.
  4. Copies of all purchase/sales documents and settlement sheets.
  5. All workpapers, schedules, and documents used to determine amount of cancellation of indebtedness income.
  6. Copies of Forms 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.
  7. Copies of Forms 1065, U.S. Partnership Return of Income, for subsequent year.
  8. QRPBI Issues-Additional Documents to request:

(a) All workpapers, schedules, and documents used to determine amount of cancellation of indebtedness income, fair market value of partnership property at time debt was cancelled, and each partner’s allocable share of depreciable partnership property.

(b) Copies of partners’ requests to General Partner to reduce basis of partnership property.

(c) Copies of partnership’s consents allowing partners to reduce basis of partnership property.

(d) Copies of partner’s elections (Form 982) to reduce the basis of depreciable real property by their distributive share of the Cancellation of Indebtedness Income.  If a partner has reduced basis of property other than partnership property, provide street address of property, percentage ownership, date acquired, cost, depreciable life and remaining adjusted basis at 12/31/XX.  In addition, if any of this property is owned by partners as partners in other partnerships, also provide the complete partnership name and address, tax identification number, name of contact person, telephone number and copy of the subsequent year Schedule K-1 received from this entity.

(e) Any appraisal of partnership property by the old or a new lender and/or by the partnership.

Interview Questions

Depending upon the documents provided by the partnership, the following questions might have to be asked.

  1. Was any partnership debt cancelled/reduced/refinanced/restructured?
  2. Was partnership debt recourse or non-recourse?  Were there any guarantees/indemnification agreements?  Was the lender advised of the guarantees/indemnification agreements?
  3. Was partnership property sold?
  4. How did the partnership determine COD income?
  5. How did the partnership determine the gain on disposition of property?
  6. Did the partnership make all principal and interest payments in the current/prior years?  If not, what was the amount of interest that was not paid in current/prior years?  Were there any standstill/forbearance agreements regarding the payment of interest?
  7. (QRPBI issue) How did the partnership determine the FMV of partnership property?
  8. (QRPBI issue) Which partners requested a reduction in their share of partnership property?
  9. (QRPBI issue) Did the partnership consent to the allowance of all partners’ requests for reduction in basis of partnership property?

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Supporting Law

General rule-IRC section 61(a)(12)
IRC section 61(a)(3)
IRC section 108 Exclusion
IRC section 469 and related Regulations
IRC section 1017
IRC section 6231(a)(5)
IRC section 461(h)(4)
IRC section 7701(g)

Sections 108 and 1017 final Treasury Regulations (applies to discharges after October 22, 1998) and related regulations:

  • Final Treas. Reg. section 1.108-4 Election to reduce basis of depreciable property under section 108(b)(5) of the Internal Revenue Code.
  • Final Treas. Reg. section 1.108-6 Limitations on the exclusion of income from the discharge of qualified real property business indebtedness.
  • Final Treas. Reg. section1.1017-1 Basis reductions following a discharge of indebtedness.
  • Treas. Reg. section 301.9100-2 Late Election filed with amended tax return within 6 months of the due date of the original return (excluding extensions)
  • Treas. Reg. section 301.9100-3 Requests for extension that do not meet the requirements of Treas. Reg. section 301.9100-2.  Taxpayer must prove that he/she acted in good faith, acted reasonably, and that the grant of relief will not prejudice the Government’s interests.

Rev. Rul. 91-31.  The reduction of the principal amount of an undersecured non recourse indebtedness (by the holder of a debt who was not the seller of the property securing the debt) results in discharge of indebtedness income under IRC section 61(a)(12).

Rev. Rul. 92-53. The amount by which a non-recourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of IRC section 108(d)(3), but only to the extent that the excess non-recourse debt is discharged.

Rev. Rul. 92-92. COD income is passive income to the extent it is allocated to passive activity expenditures at the time the debt is discharged.

Kirby Lumber, 284 U.S. 1 (1931).  Corporation that purchased its own bonds at a discount on the open market realized COD income.

Tufts, 461 U.S. 300 (1983) and IRC section 7701(g).  FMV of property securing non-recourse debt shall be treated as not less than the amount of the debt.

Gershkowitz v. Commissioner, 88 T.C. 984 (1987).  COD income was realized when non-recourse debt was canceled and debtor retained property.

Merkel, TC Memo 1954-82.  Insolvency is the amount by which the taxpayer’s liabilities exceed the FMV of the taxpayer’s assets immediately before the discharge.

Merkel, 109 T.C. 463 (1997), aff’d, 99-2 USTC Par. 50,848 (9th Cir. 1999).  Taxpayers were not allowed to include contingent liabilities (guarantees) in their insolvency computation.

Bressi, TC Memo 1991-651.  The burden of proving insolvency is on the taxpayer.

2925 Briarpark, Ltd., TC Memo 1997-298, aff’d 99-1, Par. 50,209, (5th Cir.).  Partnership sold a building subject to non-recourse debt to a third party.  The sales proceeds went to the lender who discharged the difference between the debt and sales proceeds.  The partnership argued that two transactions had taken place.  A discharge of indebtedness where the partnership retained the property, and a subsequent sale.  Both courts agreed that there was only one transaction, a sale/exchange and the sales proceeds equaled the amount of the non-recourse debt (Tufts and IRC section 7701(g)).  Also, the courts treated the difference between the portion of the debt that was guaranteed and the amount paid to settle the guarantee as Tufts gain.

The fair market value of assets that are exempt under state law are not excludable in determining insolvency.

Resources

  • BNA, Tax Management Portfolio 541
  • “A Requiem for Fulton Gold”, Taxes, (July 1994)
  • IRS-Publication No. 541, “Partner’s Exclusions and Deductions”
  • MSSP Passive Activity Guide
  • “Contingent Debt Taken into Account in Determining Insolvency”, The Tax Adviser, (March, 1999)
  • “IRS Finalizes Regs. On Basis Reduction Excluded DOI Income”, The Tax Adviser, (March, 1999)


CANCELLATION OF DEBT AND PARTNERSHIP/PARTNERS

 

 

Qualify for

IRC section 108 

 

 

QRPBI 

 

Farm

Debt

 

 

Debt Reduced –

IRC section § 61(a) (12) Taxable v. IRC section § 61(a)(3) Sale/Exchange 

 

 

 

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ISSUE:  DISPOSITION OF PROPERTY SUBJECT TO NON-RECOURSE DEBT AND UNPAID INTEREST

When real property subject to non-recourse debt is disposed/sold (that is, sale to third party, involuntary foreclosure sale, deed in lieu of foreclosure, abandonment of property subject to non-recourse debt, etc.), the outstanding mortgage debt is considered sales proceeds (Tufts v. Commissioner, 461 U.S. 300 and IRC section 7701(g)).  Therefore, the gain (IRC section 1001(a)) will equal the difference between amount of the debt (Treas. Reg. section 1.1001-2(a)(1)) and the adjusted basis of the property regardless of the property’s fair market value.  In most cases the gain will be treated as capital gain (IRC section 1231) by the partners, unless part/all of the gain has to be treated as differently due to the following provisions:

  1. IRC section 1245 - All depreciation on IRC section 1245 property is treated as ordinary income.
  2. IRC section 1250 - Excess depreciation above straight-line depreciation is recaptured as ordinary income.
  3. Unrecaptured IRC section 1250 gain - For sales of depreciable real property after May 7, 1997, depreciation not recaptured under IRC section 1250 as ordinary income is taxed at 25 percent (straight line depreciation) under IRC section 1(h).
  4. Unrecaptured IRC section 1231 losses - Any current year net IRC section 1231 gain, which would otherwise be characterized as capital gain, will be treated as ordinary income to the extent it does not exceed non-recaptured net IRC section 1231 losses.  Non-recaptured net IRC section 1231 losses are the aggregate amount of net IRC section 1231 losses for the 5 most recent preceding taxable years reduced by any amount already recaptured in a prior year.  This issue would not be raised at the partnership level, but is an “affected item” to be determined by reviewing the individual partner’s preceding five income tax returns for the existence of unrecaptured net section 1231 losses (that is, an affected item report must be prepared).
  5. IRC section 111 - Tax Benefit Rule may be cited to treat accumulated unpaid accrued interest expense and real estate taxes that will not be paid on the disposition of real estate financed by non-recourse debt as ordinary income.  When real estate is sold at a foreclosure sale, a partnership abandons property (tax sale or quit claim deed), or the partnership reconveys the property to the lender (that is, deed in lieu of foreclosure), there will normally be little or no cash available to pay the accumulated unpaid accrued interest and real estate taxes.  If real estate is sold and the sales proceeds are sufficient to pay off the outstanding debt, accumulated unpaid accrued interest, and accumulated unpaid real estate taxes, then IRC section 111 does not apply.

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Unpaid Accrued Interest

IRC section 163 provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

Unpaid current year accrued interest is not allowed in the year of disposition (IRC section 461(h)). 

IRC section 461(h)(1) provides:

For purposes of this subtitle, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

IRC section 461(h)(4) provides:

For purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.

Treas. Reg. section 1.461-4(e) provides that economic performance occurs as the interest economically accrues.

At the time of disposal or sale of the property, there is no liability to pay any interest.  If interest has been accrued during the year and it will never be paid, there is no fact of liability.

Prior year accrued unpaid interest expense should be recaptured as ordinary income to the extent of Tufts gain (loan balance +accrued interest-adjusted basis).

IRC section 111(a) provides that “Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.”

Therefore, a taxpayer that has deducted an expense in a prior year and received a tax deduction (that is, tax benefit) for the expense should have to recapture the expense in income in the year it is determined the expense will never have to be paid.

Example 8-8

Non-recourse debt exceeds fair market value

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FACTS:
 

 

DEBT 

1,000,000

ACCUMULATED ACCRUED INTEREST 

125,000

CURRENT YEAR ACCRUED INTEREST 

25,000

FMV 

500,000

ADJUSTED BASIS  

100,000


     

    


 

ADJUSTMENTS: 

 

DEBT (AMOUNT REALIZED)  

1,000,000

ADJUSTED BASIS 

(100,000)

GAIN ON SALE 

900,000

  

 

 

ACCRUED INTEREST INCOME (IRC section 111(a))=125,000
DEDUCTION CURRENT YEAR INTEREST EXPENSE=-0-

Example 8-9

Non-recourse Debt and new lender (Allan, supra,)

If debt is with a new lender or there is a 3rd party guarantor or insurer, an issue can be raised under IRC section 111.  However, the 8th Circuit ruled differently in Allan, et al. v. Commissioner, U.S. Court of Appeals, 8th Circuit, 86-2268, September 16, 1988.  Currently, this decision is being followed only in the 8th Circuit.

In this case a partnership owned an apartment building subject to a non recourse HUD insured mortgage.  The partnership was in default and HUD acquired mortgage from lender.  HUD paid the real estate taxes on behalf of the partnership.  According to the mortgage terms, HUD added unpaid accrued interest and the taxes it paid to mortgage principal.  Interest was also charged on the additions.  The partnership transferred property to HUD in lieu of foreclosure.  The partnership treated the mortgage principal, unpaid accrued interest, and unpaid real estate taxes as sales proceeds (Tufts and IRC section 7701(g)).  The Court of Appeals determined that the additions of the unpaid accrued interest and real estate taxes to the mortgage principal were like new loans (that is, mortgage principal) to the partnership from a third party that were used to pay the interest and taxes.

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Example 8-10

Using same facts as in Example 8-8:

ADJUSTMENTS:

 

DEBT 

1,000,000

ACCUMULATED ACCRUED INTEREST 

125,000

SUB-TOTAL
(AMOUNT REALIZED)  

1,125,000

ADJUSTED BASIS 

(100,000)

GAIN ON SALE 

1,025,000

  
  

 

 

 

The deduction for current year interest is zero. 

Examination Techniques

To determine whether the partnership has deducted accrued unpaid interest expense, inspection and analysis of loan documents, loan payment histories, and interest expense schedules/workpapers is required.

Issue Identification

  1. Comparison of the current and prior year partnership tax return balance sheet shows an increase in liabilities.  This may be due to the accrual of unpaid interest expense.
  2. A schedule attached to the partnership tax return may list an account called “Accrued Interest Payable.”

Documents to Request

  1. Partnership Agreement and all amendments
  2. Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees and/or loan indemnification agreements.
  3. Copies of all purchase/sales documents and settlement sheets.
  4. All workpapers, schedules, and documents used to determine amount of interest expense deduction
  5. Copy of audited financial statements.
  6. Copies of Forms 1065, U.S. Partnership Return of Income, for prior and subsequent year.

Interview Questions

  1. In the year of disposition of partnership property did the partnership deduct accrued and unpaid interest?  If yes, what was the amount of the deduction?
  2. Did the partnership include accumulated accrued and unpaid interest expense in the amount realized upon disposition of the partnership property?  If yes, what was the amount included?

Supporting Law

IRC section 111
IRC section 163
IRC section 461(h)
IRC section 1001(a)
IRC sections 1231, 1245, & 1250
IRC section 7701(g)
Treas. Reg. section 1.461-4(e)
Treas. Reg. section 1.1001-2(a)

Tufts v. Commissioner, 461 U.S. 300, and IRC section 7701(g) ─ The non-recourse obligation is considered sales proceeds.

Allan, et al. v. Commissioner, 86 TC 655, U.S. Court of Appeals, 8th Circuit, 86-2268, September 16, 1988, 856 F.2d 1169 ─ If debt is with a new lender or there is a third party guarantor, then IRC section 111 interest income issue can be raised, except in the 8th Circuit.

McConway & Torley Corp. v. Commissioner, 2 T.C. 593.
Shellabarger Grain Products Co., 2 T.C. 75.
Courts did not allow deduction for current year unpaid accrued interest in year debt was canceled.

Theodore A. Frederick, et al. v. Commissioner, 101 T.C. 35 ─ This case provides an excellent background on the tax benefit rules (IRC section 111).  However, the facts in this case do not deal with the disposition of real property subject to non-recourse debt.

Hillsboro Natl. Bank v. Commissioner, 460 U.S. 370 (1983) ─ Background on tax benefit rules (IRC section 111).  Referred to in Frederick.

Resources

Publication 544 - Sales and Other Dispositions of Assets

See Accrued Interest

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ISSUE:  ACCRUED CONTINGENT INTEREST

In situations where an accrual basis borrower is having difficulty making loan payments a lender may modify the non-recourse loan terms.  For example, a lender may require that interest be paid only to the extent of available cash flow and any unpaid balance will be payable in the future.  In other words the lender will only be paid the “accrued” interest if the property securing the non-recourse debt appreciates in value sufficiently to pay it out of sales or refinancing proceeds.  This type of loan modification is called a Standstill or Forbearance Agreement.

In some cases the lender won’t modify a non-recourse loan and the borrower will accrue, deduct and fail to pay interest year after year.

As previously discussed, interest could only be accrued and deducted in the year that the liability to pay becomes definite and absolute, regardless of the actual time of payment (IRC section 461(h)(1) and (4), Treas. Reg. section. 1.461-4(e)).

If the obligation to pay interest is wholly contingent upon the happening of a subsequent event (that is, cash flow, profitability, etc.) that can be manipulated, then interest may not be accrued and deducted until the contingency is satisfied.

In Pierce Estates, Inc. v. Commissioner, 195 F.2d 475 (3rd Circuit 1952) the taxpayer used the accrual method of accounting.  Interest was payable only if the company had “net income that was declared by board of directors” (contingency).  In its conclusion, the court stated:

If the liability to pay the item of expense is wholly contingent upon the happening of a subsequent event, the item cannot be regarded as incurred or deductible as accrued until the year in which by the occurrence of the event the contingent liability becomes and absolute one.

In Peoples Bank & Trust Co., 50 T.C. 750, the bank paid interest on deposits on May 1st and November 1st.  Interest paid on May 1st was contingent upon whether funds were still on deposit as of close of business on April 30th.  The bank used the accrual method of accounting and the calendar year.  An “experience” factor was used to calculate interest expense deducted for November and December.  The Tax and Appeals Courts determined that the bank had no liability for interest until May 1st.  Therefore, the “all events test” had not been met and the deduction for interest expense was disallowed.  In addition, a change in accounting method (IRC section 481) adjustment was made

In Burlington-Rock Island Railroad Company, 321 F.2d 817, the taxpayer used the accrual method of accounting.  It entered into an “Allocation Agreement” that required payments on judgements owed “*** from time to time, insofar as its cash situation will reasonably permit.”  It accrued an interest deduction.  However, the interest was not paid.  The judge denied Burlington’s interest deduction.

In situations where there is no Standstill or Forbearance Agreement and the borrower has been in default (that is, not paying the required principal and interest on the non-recourse loan) for multiple years, the liability to pay interest will be considered subject to a contingency.  However, prior to considering whether the interest payment is subject to a contingency the examiner should determine if a “true” debt exists (that is, debt versus equity).

The accrual of interest expense involves the timing of claiming a deduction (Treas. Reg. section 1-446-1(e)(2)).  If it is determined that interest expense has been improperly deducted, then a change in the taxpayer’s method of accounting should be made.  In addition to the current year disallowance of the contingent interest expense deduction a cumulative adjustment will need to be made for the contingent interest expense improperly deducted on prior year returns (IRC section 481(a) adjustment).  This adjustment prevents the duplication of the expense and reflects the difference between the “new” and “old” treatment of interest expense as of the beginning of the year of change.  The IRC section 481(a) adjustment should be made in the earliest year of the examination and no 4-year spread should be allowed (Notice 98-31 and Rev. Proc. 97-27).

If a positive IRC section 481(a) adjustment over $3,000 is made, then the adjustment is subject to IRC section 481(b) and the related regulations.  IRC section 481(b) provides that the additional tax (increase in tax) attributable to the IRC section 481(a) adjustment is the lesser of the increase in tax computed:

  1. With the net adjustment (IRC section 481(a)) included in income in the year of change
  2. Under the 3-year (spread-back) allocation rule of IRC section 481(b)(2)
  3. Under the specific allocation rule of IRC section 481(b)(2)

Since the IRC section 481(b) computation will be made at the partner level and requires additional factual determinations, an affected item report must be prepared (Treas. Reg. section 1.481-2(c)(5).

Examination Techniques

To determine whether the partnership has deducted accrued contingent interest expense, inspection and analysis of standstill/forbearance agreements, loan documents, loan payment histories, and interest expense schedules/workpapers is required.

Issue Identification

  1. Comparison of the current and prior year partnership tax return balance sheet shows an increase in liabilities.  This may be due to the accrual of contingent interest expense.
  2. A schedule attached to the partnership tax return may list an account called “Accrued Interest Payable.”
  3. Review of financial statements may indicate that partnership is not deducting contingent interest expense on financial statements, but is deducting it on tax returns.  Notes to financial statements may identify the standstill/forbearance agreement, etc. that requires the partnership to pay interest only when it has cash flow.

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Documents to Request

  1. Partnership Agreement and all amendments
  2. Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees, /or loan indemnification agreements, standstill/forbearance agreements.
  3. All workpapers, schedules, and documents used to determine amount of interest expense deduction
  4. Copy of audited financial statements.
  5. Copies of Forms 1065, U.S. Partnership Return of Income, for prior and subsequent year.

Interview Questions

  1. Did the partnership deduct accrued and unpaid interest?  If yes, what was the amount of the deduction?
  2. Why didn’t the partnership pay interest?
  3. Was there an agreement between the lender and the partnership that permitted the nonpayment of interest until there was cash flow, profitability or until some other contingency was satisfied?
  4. What was the amount of the accumulated accrued and unpaid interest expense deducted on prior year tax returns?

Supporting Law

IRC section 163
IRC section 446 and related regulations
IRC section 461
IRC section 481 and related regulations
Notice 98-31
Rev. Proc. 97-27

Pierce Estates, Inc. v. Commissioner, 195 F.2d 475 (3rd Circuit 1952)

Peoples Bank & Trust Co., 50 T.C. 750.

Burlington-Rock Island Railroad Company, 321 F.2d 817

Resources

Change in Accounting Method Technical Advisor.

ISSUE:  BANKRUPTCY

A financially troubled partnership and/or partner may file a petition in bankruptcy court.  Bankruptcy is a condition existing as the result of the actual filing of a petition under the Bankruptcy code.  The bankruptcy statutes are contained in Title 11 of the United States Code.  They provide the structure within which an individual, a partnership, or a corporation can seek relief from creditors through liquidation or reorganization.

There are five chapters in the bankruptcy code under which bankruptcy proceedings are commenced, administered and closed.  They are:

Chapter 7 – Liquidation
Chapter 9 – Adjustment of the Debts of a Municipality
Chapter 11 – Reorganization
Chapter 12 – Adjustments of Debts of a Family Farmer with Regular Annual Income
Chapter 13 – Adjustments of Debts of an Individual with Regular Income

A bankruptcy under any chapter may be voluntary or involuntary.  It is voluntary if the debtor files the petition and involuntary if the creditors file the petition.  A debtor does not have to be insolvent to file a bankruptcy petition.  With the commencement of a bankruptcy proceeding, an automatic stay is triggered.  It precludes a creditor from continuing collection activities against the debtor.  Thus, a debtor with cash flow problems may file for bankruptcy protection.  A bankruptcy stay will stop foreclosure actions and many IRS assessment and collection actions.

Most partnership and partner bankruptcies are filed under Chapter 11 and Chapter 7.  Title 11 encompasses both chapters.  It is necessary to determine which Chapter the taxpayer actually filed under to determine the tax consequences.  Both will be discussed in more detail.

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Bankruptcy Basics

Per IRM 4.10.3.1.3:

Chapter 7 – Liquidation:  A bankruptcy case in which all of the debtors (individual, corporation, or partnership) non-exempt assets are liquidated (sold) by the trustee to pay creditors’ claims or are abandoned.  The petition may be voluntarily or involuntarily filed.  Typically, the debtor has no hope of continuing business operations and/or paying debts.

Chapter 11- Reorganization:  A bankruptcy case in which debtors (individual, corporations, or partnerships) are allowed to restructure (reorganize) their debts, either by reducing their debts and/or extending the time for payment rather than liquidate.  To be confirmed by the Bankruptcy Court, the reorganization plan must be proposed in good faith and the creditors must be paid at minimum an amount equal to what they would have received had the case been filed a Chapter 7-liquidation bankruptcy.  The debtor usually remains in possession of the assets (called a debtor- in-possession or DIP) and has the same fiduciary duties and responsibilities as a trustee to general creditors.  A trustee can be appointed by the Bankruptcy Court if the creditor can show cause. A debtor may also choose to liquidate its assets in a Chapter 11 case.

Frequently a debtor will file under Chapter 11 and convert to a Chapter 7.

The Administrative Office of the United States Courts in Washington, D.C. publishes a Bankruptcy Division Public Information Series.  There is an information sheet for each of the Bankruptcy Chapters that discusses the basic concepts.  The sheets are available from the local District Bankruptcy Court.  The following information is taken from them:

Chapter 7  “One of the primary purposes of bankruptcy is discharging debts to give an honest individual debtor a “fresh financial start”.  The discharge has the effect of extinguishing the debtor’s personal liability on dischargable debts.  In a chapter 7 case, however, a discharge is available to individual debtors only, not to partnerships or corporations (11 U.S.C. section 727(a)(1)).  Although the filing of an individual chapter 7 petition usually results in a discharge of debts, an individual’s right to discharge is not absolute.  A bankruptcy discharge does not extinguish a lien on property.”

“The primary role of a chapter 7 trustee in an “asset” case is to liquidate the debtor’s nonexempt assets in a way that maximizes the return to the debtor’s unsecured creditors *** the trustee will attempt to liquidate the debtor's nonexempt property.  This includes both property that the debtor owns free and clear of liens and property which has a market value above the amount of any security interest or lien and any exemption (lawsuits) belonging to the debtor, and will pursue the trustee’s own causes of action to recover money or property under the trustee’s “avoiding powers””.

“Most claims against an individual chapter 7 debtor are discharged.  A creditor whose unsecured claim is discharged may no longer initiate or continue any legal or other action against the debtor to collect the obligation.  Among the debts which are not discharged in a chapter 7 case are alimony and support obligations; certain taxes; debts for certain educational loans made or guaranteed by a governmental unit and debts for personal injury caused by the debtor’s operation of a motor vehicle while the debtor was intoxicated from alcohol or other substances. 11 U.S.C. section 523(a)”

“Because secured creditors retain some rights which may permit them to seize pledged property, even after a discharge is granted, a debtor wishing to keep possession of the pledged property, such as an automobile, may find it advantageous to "reaffirm" the debt rather than surrender the property*** The debtor may repay any debt voluntarily, whether a reaffirmation agreement exists (11 U.S.C. 524(f))."

Chapter 11 “The plan must be voted upon by those creditors who are “impaired” meaning those whose contractual rights are to be modified or who will be paid less than the full value of their claims (11 U.S.C. section 1126).”

“Like a corporation, a partnership exists separately and apart from its partners; however the partners’ personal assets may, in some cases, be used to pay creditors in the bankruptcy case; or the partners may; themselves, be forced to file for bankruptcy protection.”

“Under certain circumstances, such as when the debtor has no equity in the particular property and that property is not necessary for an effective reorganization, the secured creditor can obtain an order from the court granting relief from the automatic stay to foreclose on the property, sell it, and apply the proceeds to the debt (11 U.S.C. section 362(d).

“While some courts have a practice of issuing a discharge order in individual cases, a separate order of discharge is usually not entered in a chapter 11 case, because the discharge given to the debtor is one of the effects of confirmation as set forth at 11 U.S.C. section 1141(d).  Section 1141(d)(1) provides that the confirmation of a plan discharges the debtor from any debt that arose before the date of confirmation.  After the plan is confirmed, the debtor is required to make plan payments and is bound by the provisions of the plan or reorganization.  The confirmed plan or discharge creates new contractual rights, replacing or superseding prebankruptcy contracts.

There are certain types of debtors and debts that cannot be discharged.  For example, certain types of debt are denied discharge under section 727(a).  In addition if the debtor is a corporation or partnership, confirmation of the plan does not discharge the debtor if the plan is a liquidation plan, and if the debtor does not engage in business after ”consummation” of the plan.  If the debtor is an individual, the debts excepted under 11 U.S.C. section 523(a) are not discharged.”

Bankruptcy Code Section 554 provides that a trustee in bankruptcy may abandon assets that are burdensome or of inconsequential value to the estate.  The courts have held that the abandonment of an asset relates back to the commencement of the case, so that the burdensome asset never even enters the estate. Nevin 135 B.R. 652 ( Bankr. D. Haw, 1991), Dewsnup (1990, CA10 Utah), Saunders Tool Supply, Inc. (1987 BC MD Fla) 73 BR 55.

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Partnership Bankruptcy

Return Filing Requirements

The filing of a bankruptcy petition does not create a separate taxable entity, IRC section 1399, nor does it terminate the partnership.  A partnership is deemed terminated only when it is no longer carrying on any business, financial operation or venture, or there has been a sale or exchange of 50 percent or more of the partnership interests in capital and profits within a 12 month period, IRC section 708.

Since there is not a separate bankruptcy estate, a Form 1065 should be filed that shows all of the partnership activities for the entire year.  Several scenarios can arise:

  1. No return is filed.
  2. A trustee files a 1065 that reflects only the activity occurring under the administration of the bankruptcy court.
  3. A partner files a return reflecting only prepetition activity or activity with respect to abandoned property.
  4. The trustee and a general partner both file returns

If no return is filed, substitute for return procedures must be followed.  If there is a debtor in possession with respect to all of the partnership assets, a general partner can act on behalf of the partnership.  Generally, it will be the general partner with the largest interest.

The instructions to the Form 1065 state that a trustee will file a return for a partnership in bankruptcy.  IRC section 6012 addresses a trustee filing a return on behalf of an individual or a corporation in bankruptcy but not a partnership.  Chief Counsel Directives Manual relies upon Riverside-Linden Inv. Co., 99 B.R. 439, 446 (9th Cir., BAP 1989) in stating that the trustee in bankruptcy is responsible for filing a partnership tax return.  There are authors that question whether a return filed by a trustee is legally valid.  IRC section 6063 requires one of the partners to sign a partnership tax return.

A partnership return is an information return.  If an agent is dealing with a non-TEFRA return, the tax impact is only on the partners.  Each individual partner is entitled to full legal process with respect to any proposed deficiency.  Thus whether the trustee or a general partner filed an original return is irrelevant with respect to the partner’s tax return.

There are penalties for failure to file a required return and timely furnish a Schedule K-1 to partners.  If neither the trustee nor a general partner files a return, Counsel should be consulted with respect to any potential liability based on the facts and circumstances of the case.

If a case falls under the provisions of TEFRA, the examiner must follow TEFRA procedures.  Under these procedures only a Tax Matters Partner is eligible to act on behalf of the partnership.  A trustee in bankruptcy is not qualified as a TMP  (See IRC section 6231).  The agent needs to determine who is the TMP in order to issue the NBAP, secure agreements, and secure statute extensions.  Even if a trustee for the bankruptcy court filed a partnership tax return, he or she is not empowered to be a tax matters partner.

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Debt Forgiveness

In a Chapter 7 bankruptcy or liquidation of a partnership, it is clear that the assets are to be sold and the creditors are to be paid.  Each sale must be considered as if it occurred outside the bankruptcy court since the filing of a petition for bankruptcy protection does not create a separate taxable estate.  Gain or loss must be determined on an asset by asset basis.  Keep in mind that the bankruptcy schedules show the fair market value of assets and not the tax basis.

If the proceeds of the sale exceed the debt, then the excess will be distributed to the partners.  Any gain is fully taxable to the partner since there is a sale or exchange rather than cancellation or debt.  A partner may not exclude the gain because a bankruptcy trustee handled the sale.

If the proceeds of the sale are insufficient to pay the debt, then the general partners are still liable.  The trustee and/or the creditors may take legal action against the general partners.  The suit is filed with the court that would have jurisdiction over the debt if the bankruptcy petition had not been filed.  The trustee may receive a judgement against the general partners, which will become an asset of the bankruptcy estate.  If the creditors file suit against the general partners, the court will generally issue a deficiency judgement against the partners.  This information will not be contained in the bankruptcy file.  If the partner’s all pay the proportionate share of the remaining debt, then there are no additional issues.  If one partner pays more than his or her share of the debt, then you must look to any deficit restoration agreement and the legal rights the payer partner has against the other partners for co-contribution.

The bankruptcy file may contain the court and file numbers for related litigation.

Frequently, neither the trustee nor the creditors take legal action against the general partners.  If this is the case, the issue is, when is the debt forgiven?  The courts have held that debt is forgiven when the facts reasonably establish that the debt will probably never be repaid, the taxpayer does not intend to repay to debt, and the creditor does not intend to enforce it’s claim against the taxpayer.  (M.A. Slavin v. Commissioner, 57 T.C. Memo 1989-221.)

If the assets are gone, and the partnership is no longer conducting business, a final partnership return should be filed and the individual partners will determine any gain or loss on the termination.

In a chapter 11 proceeding the intent is to restructure the debt or reorganize the partnership.  A plan of reorganization is submitted to the court. The majority of creditors must approve the plan.  The plan is then confirmed by the court and is binding on the debtor.  A revenue agent will have to look at any debt that is modified and determine if the material modification rules of IRC section 1001 apply. Under Treas. Reg. section 1.1001-3(c)(iii), a modification occurs upon the effective date of the plan.

Other issues to consider with respect to a partnership bankruptcy are the deductibility of expenses and allocations.  Administrative expenses of bankruptcy are generally deductible.  To the extent that they relate to the reorganization of the partnership, they may have to be capitalized.

Where there are significant tax effects, the partnership may attempt to allocate the gain to a partner where the impact will be minimal.  Any allocation must satisfy the substantial economic effect requirements and the partnership minimum gain provisions of IRC section 704.

Each Schedule K-1 should clearly reflect any income from a sale or exchange and any income that qualifies as cancellation of indebtedness (COD).  Watch for recourse and non-recourse debt and “Tufts” gain.

Under IRC section 108(d) the determination of whether COD income is excludable is made at the partner level.  The fact that the partnership filed for bankruptcy does not mean that any income is excludible because COD arose during the jurisdiction of the bankruptcy court.  The partner must be actually file for bankruptcy or meet the insolvency exception provided in IRC section 108.

Partners Bankruptcy

This section will address the filing of bankruptcy by a partner who is an individual.

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Return Filing Requirements

If a partner who is an individual files for bankruptcy, a separate taxable estate is created.  The estate is separate and distinct from the individual debtor.  At the date of the petition all of the debtors non-exempt assets and liabilities pass to the bankruptcy estate.  Among the assets that pass are the taxpayers tax attributes: NOLs, carryover contributions, recovery of tax benefit items, credit carryovers, basis, method of accounting, passive activity losses, unused at-risk deductions and any other item specified in the regulations.  No gain or loss occurs upon the transfer of the assets, liabilities, and attributes to the bankruptcy estate.  The gross income of the bankruptcy estate includes any of the debtor’s gross income to which the estate is entitled under bankruptcy law.  The estate’s gross income also includes any income the estate is entitled to and receives or which accrues after the commencement of the bankruptcy estate. (IRC section 1398).

Exempt assets are determined under state law.  In general, exempt assets include a limited interest in a personal residence and personal property such as an automobile and clothing.  Many states have adopted the exemptions set forth in Section 522 of the Bankruptcy Code.

The individual debtor is responsible for reporting any personal income or expense after the date the bankruptcy is commenced.  He or she is responsible for filing personal income tax returns for income prior to the commencement of the bankruptcy case and income after the bankruptcy case that does not belong to the bankruptcy estate.  If married one or both spouses may file for bankruptcy.  The taxpayer can elect to file a short period return for the period prior to the commencement of the bankruptcy estate.  See Publication 908, Bankruptcy Tax Guide for additional details

The trustee of the estate or the debtor in possession is responsible for filing a fiduciary return (Form 1041) for the bankruptcy estate.

Warning:  The filing of a petition in bankruptcy disqualifies the individual debtor as a tax matters partner in TEFRA proceedings.  In addition it converts the debtor partner’s TEFRA items to non-TEFRA items and starts the running of the 1-year assessment date provided for in IRC section 6229.  Advice has been received that this period should not shorten the normal 3-year statute of limitations provided for in IRC section 6501.  This issue has not been litigated.  The current position is to protect the one-year period.  Contact your TEFRA Coordinator for assistance.

The individual debtor is required to file the bankruptcy schedules listed at the beginning of the discussion on bankruptcy. 

These schedules will detail what the assets and liabilities of the partner are at the date of the petition.  These are the assets that pass to the bankruptcy estate unless they are exempt.  On the personal property schedule, the partnership(s) interest should be listed with a fair market value assigned.  In the secured liability schedule, a partnership interest may be shown as security for a debt.  In addition partnership debts may be listed on either the secured or unsecured schedule.

The trustee or the debtor in possession may offer the partnership interest for sale just as he would any other asset.  Generally they are offered for sale to the other partners as most partnership agreements have restrictions on the admission of new partners.  If the interest is sold while held by the estate, then there is a taxable gain or loss based on the difference between the proceeds and the partner’s basis that was transferred to the estate.

If the asset is burdensome to the estate or of inconsequential value, it may be abandoned back to the partner.  If the tax basis is low the estate may want to abandon the interest as a sale may produce adverse tax consequences.  Whoever sells the property is liable for any tax due.  A trustee sold property and attempted to abandon the proceeds to the debtor.  The court held the estate liable for the tax.  (Bentley, 916 F2nd 431, 8th Cir. 1990).  A trustee will also abandon property that is pledged as security for a debt that exceeds the property’s value.

One collateral consequence of this is that if a partnership interest is abandoned back to a partner, then the related tax attributes go with it.  For example, passive loss carryovers related to an abandoned partnership will be returned to the debtor (See Treas. Reg. section 1.1398-1(d)) as well as all income and expense related to the property.

A partner will list partnership debt on his or her personal bankruptcy schedule.  Usually this is because the debt is recourse or the debt is non-recourse but has been guaranteed by the partner. 

Debt Forgiveness

Just because a debt is listed on a bankruptcy schedule, it does not mean that it is forgiven.

In chapter 7, the court discharges the partner’s personal debt unless they are non dischargable.  If a debt is fully secured it is not discharged since the court cannot discharge a lien.  The creditors claim will show the amount or the debt that is secured and the amount that is unsecured. See the general discussion above with respect to general debts and the Bankruptcy Handbook (IRM 4.3.2) for additional information.

A court cannot discharge a partnership debt since it is the partner who is under court jurisdiction.  A guarantee is however discharged.  A debt that was recourse will be converted to non-recourse.  Thus, a partner will have a deemed distribution that may result in taxable gain if the distribution exceeds the partner’s adjusted basis of its partnership interest.

The actual discharge of the individual debtor may be as early as 60 days after a chapter 7 petition is filed.  The bankruptcy estate may continue for a substantial period of time beyond the discharge. 

In a chapter 11 case, any debt modifications will be spelled out.  As with a partnership consideration must be given to the material modification rules set forth in IRC section 1001 and the regulations thereunder.

Income Issues

Under IRC section 706, a partner recognizes the partnership income or loss in the tax year in which the partnership’s taxable year-end occurs.  Thus if a partner files for bankruptcy a separate bankruptcy estate is created.  If the partnership’s year-end is after the petition date but prior to the estate's year end, the partnership income or loss is allocated to the estate for the entire year.  Aron B. Katz, etux.v. Commissioner; 116 T.C. No.2 (January 12,2001).  Determination of the owner of a partnership interest at year-end is critical to determine who is taxable on any income or loss.

If a bankruptcy case is dismissed, it is as if no petition was ever filed.  Amended returns are required to reallocate any income/expense reported by the estate back to the individual debtor.

If a debt is converted from recourse to non-recourse it is a deemed distribution under IRC section 752.

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Court Records

Frequently, the agent is examining a return subsequent to the bankruptcy termination.  On a partnership Schedule K-1, cancellation of debt may be reflected as “Other Income” or there may be a notation that the assets have gone through foreclosure or bankruptcy.  The individual partners may or may not reflect the information on their individual Forms1040 depending on the knowledge and skill of the person preparing the tax return.  Often partners in the same circumstances and in the same partnerships will have inconsistent positions in the manner they reported it on their personal returns.

To make a proper determination of a partner’s tax liability, the examiner’s first step is to determine what was sold and what was forgiven.  In order to do so a basic understanding of bankruptcy is necessary.  It is a highly complex area of law.  The agent should review the bankruptcy file and interview the taxpayer to obtain the facts.  Usually it is clear if an asset was sold or debt was forgiven.  If there is any question, a request should be made for a legal opinion from Counsel.

A taxpayer/debtor often believes that there are no tax implications as they lost the property.  Since the bankruptcy is closed, they believe that all related matters are also closed.  This is incorrect, as audit issues may still be raised on non-bankrupt partners, and proof of claims filed against the bankrupt partners.

The files at the US Bankruptcy Court contain a wealth of information.  It is all public record.  The filing of the petition requires the completion of detailed financial records.  The petitioner is required to submit the following schedules when they file for bankruptcy protection:

A –Real Property
B – Personal Property
C – Property Claimed as Exempt
D - Creditors Holding Secured Claims
E – Creditors Holding Unsecured Priority Claims
F – Creditors Holding Unsecured Nonpriority Claims
G – Executory Contracts and Unexpired Leases
H – CoDebtors
I – Current Income of Individual Debtors
J – Current Expenditures of Individual Debtors

For both partnerships and partners, the schedules provide a balance sheet at the date of filing the bankruptcy petition.  It should be kept in mind that the assets are listed at their fair market value rather than their tax basis.

A series of questions in the schedules will provide a revenue agent with information on other litigation, related parties, and recent asset transfers. 

Listed creditors are notified of the filing of the bankruptcy and are generally given 90 days to file a claim.  If a debtor lists the debt as non- liquidated and non-contested in the schedules, no formal claim is required from creditors as it is deemed to be correct.  All other creditors must file formal claims to state the amount and basis of the claim.  As a proof of claim, the creditor will often attach the legal contract that gave rise to the debt or invoices previously submitted to the debtor.

Throughout the period of administration income and expense reports are filed with the bankruptcy court.  If there is a receiver or a debtor in possession in a Chapter 11 case, the reports are required on a monthly basis.

The trustee or the debtor in possession has the right to set aside or void an executory contract or lease that is not favorable to the debtor.

When the bankruptcy is finalized a final accounting is contained in the bankruptcy file.

The bankruptcy file contains an index that lists all documents contained within the file.  When a revenue agent learns of a bankruptcy, he should review the bankruptcy files.  Many of the Bankruptcy Courts have a web site containing detailed information that can be reviewed or downloaded by computer.  Some of the courts are scanning in certain documents received.  Actual records may be reviewed at the bankruptcy court.  If this is not practicable, then the agent should request from the clerk of bankruptcy court copies of the petition, related schedules, index, and final accounting.

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Examination Techniques

Prior to or during an examination, an agent may become aware that a partnership and/or a related partner have filed for bankruptcy protection in one of the following ways:

  • The courts are to inform Special Procedures with respect to bankruptcies filed within their jurisdiction.  After notification, Special Procedures researches the debtor’s tax filings and notifies Compliance if the debtor has an open income tax examination.
  • The agent may find out prior to receiving official notice.
  • The taxpayer may tell him/her that he/she filed.
  • There may be a bankruptcy freeze code on the case.
  • The agent may receive an AIMS update with the bankruptcy freeze code.
  • There may be some indication on the return that the taxpayer is in bankruptcy.  For example, the taxpayer may have filed Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness in the year COD income is received).
  • The agent may see it in the newspaper.

The agent must immediately evaluate the case. Collectibility needs to be considered (IRM 4.3.2).  A survey or limited scope audit may be appropriate.

With respect to any open case, the examining agent is responsible for notifying Special Procedures with the amount of the deficiency or a reasonable estimate thereof.  Some taxes are not dischargable in bankruptcy.  However, a detailed discussion is beyond the scope of this guide.  The claim to be submitted to the bankruptcy courts is for all taxes, interest, and penalties with respect to any taxes due for any prepetition period.  It includes assessed amounts and potential audit deficiencies.  The bankruptcy court sets a date by which all claims by creditors must be filed.  This date is know as the bar date.  If a claim is not timely filed it is not allowed.  In general, a claim may later be perfected but not for a larger amount.

Since a partnership is not a taxable entity, frequently there is no claim to submit.  However, consideration should be given to any liability for employment and excise taxes.  The filing of a petition by an individual partner creates a bankruptcy estate, which is separate and distinct from the taxpayer.  Taxes incurred by the estate during the period of administration of the estate are deductible by the estate.  The trustee may make a request for prompt assessment.  The tax determination must be made within 180 days of the receipt of the request. See IRM 4.2.10.5.2.  Prompt assessments do not apply to partnerships as no separate taxable estate is created.

District Counsel must be notified under the following circumstances: (IRM 4.3.10.1.3)

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1) Significant Processing Procedures  (IRM 4.3.10.5.2)

A) CEP cases
B) Cases with coordinated issues
C) Cases with technical advice pending
D) Cases with assets of $50 million dollars or more
E) Cases where the tax liability may exceed $1 million or the assessed liability exceeds $10 million
F) Cases where the potential tax liability may generate significant publicity
G) Cases where a criminal tax prosecution is being considered or pending
H) Past or present subsidiaries that joined in filing consolidated returns with a parent that meets the above criteria
I) Parent corporations where the past or present consolidated subsidiaries meet the above criteria
J) Cases where the agent deems it warranted
K) Cases with difficult or significant post confirmation tax issues
L) Cases that involve excise tax or ERISA issues
M) Prepackaged bankruptcies

2) Litigation is brought against the IRS in the bankruptcy proceeding
3) Consideration is being given to referring the taxpayer to Criminal Investigation
4) Consideration is being given to asserting a transferee liability
5) Assets were transferred within 90 days prior to the bankruptcy petition

Issue Identification

Partnership

  • Have all assets and debt dispositions been accounted for?
  • Are there sales or exchanges?
  • Is there debt forgiveness?
  • Has there been a material modification of debt?
  • Will a change in the debt qualify as a purchase price adjustment?
  • Was any of the debt acquired by related parties?
  • Was all income reported during the period of bankruptcy administration?
  • Has all of the income from abandoned assets been included in the partnership return?
  • Have there been asset transfers within the year prior to filing the petition for bankruptcy protection?
  • Does the Schedules K-1 clearly and accurately reflect the nature and amount of income loss and changes in capital?
  • Has a partnership interest been issued in exchange for debt?

Partner

  • Has the partner included all Schedule K-1 income and loss?
  • If a related partnership filed for bankruptcy, has the partner excluded income due to the partnership’s filing for bankruptcy?
  • Did the partner file for bankruptcy?
  • Does the partner contend that he or she is insolvent?
  • Are all assets included?
  • Is the fair market value of the assets understated?
  • Are debts overstated?
  • Is any of the debt contingents?
  • If COD has been excluded were the tax attributes reduced?  See Firsdon v United States, 75 AFTR, 2d 95-368.
  • If basis within a partnership was reduced, was the outside basis reduced?
  • Were there any asset transfers within 3 months of the bankruptcy petition?
  • Did the debtor reaffirm or voluntarily pay and debt?

Documents to Request

  1. Last filed return prior to filing for bankruptcy
  2. Bankruptcy petition and related schedules
  3. All post petition returns filed
  4. Calculations related to insolvency
  5. Specific schedule of excluded income and attribute reductions
  6. Related returns

Interview Questions

  1. Explain any changes on the balance sheet
  2. Was any debt forgiven during the tax years under audit?
  3. Was the partnership or any partner in bankruptcy during the year prior to the audit to the present?
  4. If yes, when was it filed?
  5. Is it still open?
  6. Do you know the bar date for creditors (IRS) to file a claim?

Supporting Law

Title 11 U.S.C.  Bankruptcy
IRC section 108
IRC section 706
IRC section 752
IRC section 1001
IRC section 1017
IRC section 1398
IRC section 1399
IRC section 6231

Resources

  • Internal Revenue Manual Section 4.3.2 - Collectibility Handbook
  • Internal Revenue Manual Section 4.3.10 - Bankruptcy Handbook
  • Publication 908 – Bankruptcy Tax Guide
  • Bankruptcy Division Public Information Series, Administrative Office of the US Courts 
  • Collier’s Bankruptcy Taxation
  • American Bankruptcy Institute Website - www.abiworld.org
  • Bankruptcy Court Websites - go through: www.legal.gsa.gov/

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ISSUE:  LOW INCOME HOUSING TAX CREDIT (IRC section 42)

The low income housing tax credit was enacted with respect to tax years after 1986 to promote affordable housing.  Each state is annually allocated tax credits based on population.  Through a competitive process, the states award their tax credits to qualifying projects based on housing needs.  Ten percent of a state's annual credit allocations are set aside for projects that include ownership and on-going involvement of not-for-profit organizations. Generally, project developers form partnerships and sell limited partnership interests to investors to finance the development and operation of low-income housing projects.  The projects are not expected to produce income for the investors.  Instead, investors look to the credits, which will be used to offset their tax liabilities, as their return on investment.

To qualify for the low income housing credit, the units must be residential rental units rented to qualifying tenants and rent restricted.  In order for a project to be awarded credits, the developer must commit to maintaining the project as low income housing for 30 years.  For purposes of IRC section 42, the credit is taken over a 10-year period (credit period) and the property must be in compliance for 15 years (compliance period).  One-third of the credit claimed each year is an “accelerated” credit since the credit period is 10 years and the compliance period is 15 years.

The credit is approximately 9 percent per year for new construction and 4 percent for rehabilitation or federally subsidized buildings.  For example, if a building has a qualified basis of $1,000,000 and a 9 percent credit allocation, a $90,000 credit will be claimed in each of 10 years for total credits of $900,000 (if the property remains 100 percent low-income throughout the 15 year compliance period).

Form 8609, Low Income Housing Credit Allocation Certification, is the allocating document for a low income housing tax credit. It is issued by the state housing agency (or a sub-allocator) when the building is placed in service and must be signed by an authorized state official.  There will be one Form 8609 for each building in a multi-building project.  Part I is completed by the state and specifies the maximum qualified basis and credit as well as the date the building was placed in service.  Part II is completed by the taxpayer in the initial year of the credit and contains certain irrevocable elections.  A copy of the initial Form 8609 must be attached to the partnership return with respect to each year of the 15-year compliance period.  The partnership must file a Form 8609, Schedule A, Annual Statement, which identifies changes to qualified basis and occupancy.  A Form 8586, Low-Income Housing Credit, must also be included with the partnership return.  It summarizes the Forms 8609, Schedule A, and should equal the total low income housing credit reflected on Schedule K of the partnership’s Form 1065.  The total credit is allocated to the individual partners on their Schedules K-1.

A partner whose ownership of low-income housing property is held only through a partnership will attach only a Form 8586 to his return to calculate credit limitations.  A Form 8609 is not required to be attached by the partner.

Annually the owners of low-income housing projects submit certification reports to the allocating agencies.  The agencies also monitor project compliance through periodic property inspections and tenant record reviews.  Noncompliance is reported by the agencies to the IRS on Form 8823, Report of Noncompliance.  The form is also used to report property dispositions.  The Form 8823 is also used to file notices of corrections of noncompliance when the state agencies have determined that the owner remedied the item of noncompliance.  The reports are filed with the Philadelphia Service Center.

If the number of low-income housing units decreases there is a corresponding recapture of the corresponding portion of the credit.  If the number of units maintained as low-income units falls below the minimum set aside (the minimum number of units that must be maintained as low-income units), then the entire amount of the credit claimed that year is disallowed (no current year credit and full recapture of the accelerated portion).  Interest on the recapture of accelerated credits runs from the due date of the return upon which it was claimed. 

If there is a disposition of a low-income property, full recapture of the accelerated portion of the credit is required unless the property is sold to a party who will maintain the property as low-income housing (and in compliance with IRC section 42).  In such cases, the taxpayer can post a bond with the IRS. If a bond has been posted the taxpayer will file a Form 8693, Low Income Housing Credit Disposition Bond and will be able to provide documentation that the bond is in place throughout the remaining portion of the compliance period.  (Note: as an alternative, the taxpayer can buy government securities.  The documentation will be comparable to the bond documentation.)  If the taxpayer recaptures the accelerated credits, it will be reported on Form 8611, Recapture of Low-Income Housing Tax Credit.

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Examination Techniques

Contact your area low income housing coordinator if you are auditing a return initiating the low income housing credit and request the assistance of an agent trained in IRC section 42.

When inspecting a partnership with a low income housing tax credit:

  1. Look for the Forms 8609 and see if the credits allocated are less than or equal to the credits claimed.  The Form 8609 should indicate whether this is new or rehabilitated construction.  The credit should be less than 9 percent of the fixed assets for new construction or 4 percent for rehabilitation.
  2. Review any available depreciation schedule to determine what is included in the credit base.  A cost incurred in the construction of a low-income housing building is includable in eligible basis if the cost is included in the adjusted basis of depreciable property subject to IRC section 168 and the property qualifies as residential rental property under IRC section 103 or depreciable property subject to IRC section 168 that is used in a common area..  For example, the cost of constructing a parking area would qualify under this test if made available to all tenants without cost.
  3. Tour the property to ensure it exists and is well maintained.
  4. Inspect the balance sheet to compare the costs of land and intangibles to the overall costs.
  5. The date placed in service will indicate how far along the taxpayer is in the credit stream.  If the balance sheet indicates a property disposition, is recapture reflected on the Schedules K-1?  Asset locator services and the web may provide additional information with respect to transfers of ownership.
  6. Consider reports of noncompliance filed by the state agency.  Information can be obtained with the assistance of the coordinator. 

Issue Identification

Auditing this issue will include, at a minimum, verification of the qualified and eligible basis (costs which are included in the computation of allowable credits), tenant qualifications, and whether rents were properly restricted.  Issues in low income housing are:

  1.  No Form 8609 was issued by state agency:
    • If a credit is shown on the partnership return, make sure that there is an Form 8609 attached
    • Make sure that the Form 8609 was timely signed by a state official
  2. The credits allocated do not match the credits claimed:
    • If the credits claimed are less than those allocated make sure that the percentage claimed is at least that shown in the minimum set aside election
    • If the credits claimed are more than the credits allocated they are not allowable.  If the taxpayers spent more than originally anticipated they need to request and receive an additional allocation to claim credits
  3. The minimum set aside was not timely met:
    • The project was not placed in service
    • The minimum set aside was not met by the end of the second year that a carryover allocation was made to a taxpayer
    • The taxpayer failed to maintain records
  4. The first year credit is not properly calculated: 
    • If the Form 8609 shows that this is the first year that a project was placed in service midyear then there should be only a part year credit
  5. Qualified basis:
    • Developer's Fee - must be reasonable and for services actually rendered, must be noncontingent, related party rules apply
    • Land Costs - allocation between land and qualified basis
    • Acquisitions Fees
    • Syndication Costs
    • Financing - Federal financing (direct or indirect), grants, contingent liabilities
  6. Living Standards – health, safety, and building codes
  7. Disposition – credit recapture or bonds
  8. Tenants are not qualified – tenants must be income qualified, full time students are not qualified unless they meet exceptions, transient use, etc.
  9. Rents not properly restricted – utility allowances, assisted services

Partnership Issues

  1. Special Allocations
    • Special Allocations are permissible within limits - See Chapter 6
  2. Recapture
    • If a partnership has 35 or more partners, the partnership is subject to recapture if applicable.  The increase in tax will be allocated to the partners in the same manner as the partnerships taxable income for the year, IRC section 42(j)(5).
  3. Tax Exempt Partners
    • If a project received an allocation based on the participation of a tax exempt entity, the entity must continue to participate for the entire 15 year compliance period
    • If there are special allocations then, the tax exempt use rules of IRC section 168 must be considered.

Partner-Level Issues

  1. Partners are subject to basis, at-risk and passive activity loss rules
    • A loss from a low income housing partnership will reduce the partners basis but a low income housing credit will not.
  2. Recapture
    • Disposition of partnership interest is a disposition of low income housing credits and subject to recapture. Exceptions: if there are more than 35 partners in the partnership, there is no recapture unless the partnership has elected out of the recapture responsibility (IRC section 42(j)) or there is a deemed termination of the partnership.
    • A partner is not subject to recapture until he or she disposes of more than 33-1/3 interest in a partnership.  Revenue Ruling 90-60.
  3. Passive Activity Losses
    • A partner must actively participate to qualify for the $25,000 offset allowed for rental losses.  A limited partner will not qualify.
      Losses from low income housing partnership interest belong on line 2 of Form 8582 for partners subject to passive activity loss rules.
    • A partner may claim a tax deduction equivalent to the $25,000 deduction without regard to participation.  This is a credit of $25,000 multiplied by the taxpayer’s tax rate.
    • The partner may not claim a $25,000 offset for a rental loss and a $25,000 credit equivalent unless he has passive income.
    • The $25,000 offset for a rental loss is before the credit
    • There is no phase out of the credit due to modified AGI
    • The credit is not allowable on property disposition but may only be used when there is passive income

Supporting Law

IRC section 42 and related regulations
IRC section 704
IRC section 168
IRC section 469

Resources

MSSP Guide for the Low-Income Housing Tax Credit (TPDS No. 89018M)

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ISSUE:  CAPTURING “PHANTOM” GAIN IN ZOMBIE PARTNERSHIPS

Sometimes a partnership will attempt to avoid Tufts gain on disposition of property by sale or foreclosure by claiming that the liability of the partnership still exists.  Without the relief of liability no gain is required to be recognized.  Partnerships which are no longer actively engaged in business but which still wander aimlessly about shedding tax benefits or postponing gain are called “Zombie Partnerships.”

How to Recognize a Zombie

A Zombie partnership has debt, a large negative capital account, and very little in the way of assets or economic activity.  Sometimes the Zombie balance sheet will show negative assets and no liabilities; this occurs where the partnership was a lower tier investor in another partnership that actually owned property and had debt which was allocated to the partnership you are examining.  If there is no income or loss allocated to your partnership, chances are that the property has been sold and the other partnership no longer exists.

A more unusual type of Zombie partnership still shows significant rental activity and property ownership, but close inspection of the rental schedule and balance sheet reveals that the rental loss is covered by depreciation and interest accruals.  This can occur where the property is acquired by using “wraparound” financing and interest is payable from cash flow. This can be illustrated by the following example.

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Example 8-11

Buyer Partnership agrees to purchase a shopping center from Seller for $125 million dollars by paying $35 million in cash and $90 million in the form of a contract for deed at 12 percent interest.  The property is subject to a $45 million First Mortgage with interest at 8 percent and the contract provides that under no circumstances can the contract payments be less than the amount required to amortize the First Mortgage.  After making the minimum payments, the buyer must pay all remaining cash flow as interest, with any unpaid interest added to the outstanding balance and accruing interest at 12 percent.  All payments over the minimum amount are applied first to the earliest accrued interest.  In the early years it is possible to argue that Buyer can profit if sales and rents at the shopping center increase enough to eventually cover the interest payments.  By year 15 however, the annual accruals for interest are greater than gross rents and the balance of previously accrued and unpaid interest is greater than the original $90 million principal balance.  At this point it is clear that Seller bears the risk of loss if the value of the shopping center declines and Buyer has an option to acquire the property in the unlikely event that it appreciates sufficiently to cover the mortgage principal and (rapidly increasing) accrued interest.  Since the entire cash flow from the property is paid to the Seller as interest and as a cash basis taxpayer none of the accrued interest is reported, only the tax benefits of ownership were transferred and not the economic benefits of ownership.

These situations also occur in older HUD mortgages on Low Income Housing and are not as rare as one might think.  When the property is sold, the amount of the accrued interest is included in the “wraparound” financing for the buyer to depreciate, but the seller does not include it in income, claiming that they have contingent liability to HUD in the event of default by the buyer; that is, the seller becomes a Zombie.

In the case of a Zombie Partnership, the Duty of Consistency prevents the taxpayer from claiming that the liability was in fact extinguished in a prior (expired) year and that the gain does not belong in the current year.  If the liability does not exist at the end of the year under examination it will be treated as an IRC section 752(b) distribution for that year.  If the taxpayer takes the position that the liability did not exist at the beginning of the year either, care must taken to ensure that each and every condition necessary for the application of the doctrine exists in your case.  See Spencer Medical Associates, TC Memo 1997-130.

In the case of operating partnerships where the interest accrual is enormous relative to the rents collected, as in the example described above, IRC section 752(c) provides that a liability to which property is subject shall, to the extent of the fair market value of such property be considered as a liability of the owner of the property.  The key is the fair market value of the property.  If the liability greatly exceeds the value of the property, the liability for the current interest accrual will not be considered a “liability of the owner of the property;” as a result, the partners will have no remaining basis to claim losses in the current or future years.

Where the mortgage greatly exceeds the value of the property, no interest or depreciation charges with respect to that loan are allowable, since to be included in basis, the note must reflect a genuine debt (Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976).  In determining whether there is likelihood of repayment, the courts look to the facts and circumstances of each case (Waddell v. Commissioner, 841 F. 2d 264 (9th Cir. 1988).  The courts do not intend to require an appraisal of all rental property every year and therefore these rules are to applied only in egregious cases.

Of course, if there is no reasonable likelihood that the interest will actually be paid, it does not meet the requirements for accrual under IRC section 461 (the all events test) and should be disallowed.  This is consistent with the Code and will eliminate the need to argue in some future year as to whether Tufts or IRC section 111 applies.  If it is not a genuine liability, it is not includable in the sales price.  On disposition of the property this argument is not available to the taxpayer since the Duty of Consistency prevents them from claiming that the debt lacks economic substance.

Examination Techniques

Issue Identification

  1. The partnership shows little or no economic activity and has a substantial negative capital account.  This may indicate that the property was disposed of in a prior year without recognition of the entire gain.  The partnership may have a negative asset on the Other Investments line indicating that it was a tiered partnership.
  2. Be aware if a partnership reports rental income and expense that results in a very large loss, no capital contributions are made, and there is a large negative capital account.  Only where interest expense accruals are very large in relation to rental income can a case be made that the partnership is a Zombie.

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Documents to Request

  1. Partnership Agreement and all amendments.
  2. Copies of all loan documents including, but not limited to promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees and/or loan indemnification agreements.
  3. If the partnership is tiered, copies of that partnership agreement and all amendments, together with all Schedules K-1 ever received.
  4. Copies of all purchase and sales documents and settlement sheets.
  5. Real Estate Tax statements (to show ownership and value).
  6. Verification, as of year end, of the amount and type of liability supporting the negative capital account.

Interview Questions

  1. What happened to partnership assets and when did it occur?
  2. What is the basis for your claim that the partnership was still liable for the debt shown on the balance sheet/Schedule K-1?
  3. To what extent do these liabilities include accruals for interest and taxes?

Supporting Law

General Rule-IRC section 752(b)
Secondary Rule- IRC section 752(c)

IRC section 752(b) provides that any decrease in a partner’s share of the liabilities of the partnership *** shall be considered as a distribution of money by the partnership to the partner.

R. H. Stearns Co v. United States, 291 U.S. 54 (1934)
This is the Supreme Court case on which the judicial doctrine of the “Duty of Consistency” is founded.  This doctrine holds that the taxpayer may be bound in the current year to a prior error or misrepresentation when the following circumstances are met:

  1. The taxpayer made a representation or reported an item for Federal income tax purposes in one year,
  2. The Commissioner acquiesced in or relied on that representation or report for that year, and
  3. The taxpayer attempts to change that representation or report in a subsequent year, after the period of limitations has expired for the year of the representation or report, and the change is detrimental to the Commissioner.

Spencer Medical Associates v. Commissioner (T.C. Memo 1997-130)
(Aff'd, 4th Cir 7/98), 98-2 USTC 50, 578

The application of this doctrine to burned out tax shelters is illustrated by this case. The taxpayer unsuccessfully contended that partnership notes used to support claimed deductions in prior years were invalid.  The Court held that since the partnership had treated them as valid in the intervening year returns, they were bound by the duty of consistency.  When the duty of consistency applies, the Commissioner may proceed as if the representation or report on which he relied continues to be true, although, in fact, it is not.

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ISSUE:  SECTION 263A ─ UNIFORM CAPITALIZATION

Uniform capitalization rules apply to partnerships involved in real estate development and construction.  Also, the rules apply to partnerships that may self-construct assets.  For example, IRC section 263A requires the capitalization of the costs of a new office building built by a law firm or construction of leasehold improvements to real property by any business.

This section does not attempt to explain all of the rules and exceptions.  A very comprehensive guide entitled Section 263 A Uniform Capitalization is available from Multimedia Production Division (Go to IRS Intranet Home Page and click on Forms/Pubs/Docs and Forms/Pubs/Products Repository).  The guide includes a detailed discussion of IRC section 263A with references to the Code, regulations, and other appropriate citations.  It also includes a six-step approach to an IRC section 263A issue.  In addition the guide contains five appendices that provide various research sources as follows:

A. Court Cases
B. Notices and Announcements
C. Letter Rulings and Technical Advice Memoranda
D. Articles
E. Contacts

IRC section 263A requires that certain direct and indirect costs (including interest under IRC section 263A(f) and taxes) be capitalized into the cost of real or tangible personal property produced by the taxpayer and real or personal property acquired for resale.  It may require capitalization of interest incurred by the partners, IRC section 263A(f)(2)(C).

IRC section 263A is a timing provision.  IRC section 263A does not create or disallow deductions; it merely changes the timing of the deduction.  In other words one must determine whether the costs would, but for IRC section 263A, be otherwise deductible.  A cost that is not otherwise deductible may not be allocated to property produced or acquired for resale.

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Pre-production Costs

If property is held for future production or if it is reasonably likely that the property will be produced at a future date, pre-production costs must be capitalized.  Costs of storing raw materials and carrying costs of realty held for development must be capitalized.

Real estate developers “*** must capitalize property taxes incurred with respect to property if, at the time the taxes are incurred, it is reasonably likely that the property will be subsequently developed.”  See Treas. Reg. section 1.263A-2(a)(3)(ii).

In addition other pre-production expenses, including but not limited to expenses related to the following must be capitalized:

  • Engineering and design
  • Architectural plans
  • Securing building permits
  • Obtaining zoning variances
  • Meetings with government officials
  • Feasibility, environmental impact, and engineering studies

Interest Capitalization ─  IRC section 263A(f)

IRC section 263A(f) provides rules for the capitalization of interest expense during the production period of designated property.  See Treas. Reg. section1.263A-8(b)(4)(I) for the De minimis “exception”.  Real property and tangible personal property (that meets certain classification thresholds) is considered designated property.  IRC section 263A(f)(4)(B) defines the production period as beginning on the date on which production of the property begins, and ending on the date on which the property is ready to be placed in service or is ready to be held for sale.  Generally, the production period begins when physical activity is first performed.  For example, the clearing of raw land, grading, excavation of foundations, etc.

Interest that is capitalized is considered part of the cost of the property produced.  It is recovered through cost of goods sold, depreciation, amortization, etc.

Interest is capitalized under the “avoided cost” method.  Interest expense directly attributable to production expenditures with respect to such property (traced debt) and interest expense on any other debt to the extent that the taxpayers interest costs could have been avoided if production expenditures had not been incurred (non-traced debt) is required to be capitalized.  See IRC section 263A(f)(2)(A).


Example 8-12

Facts:
X is constructing a building. X borrowed $600,000 at 8 percent, which can be traced to the construction of the building.  X’s only other debt was a $700,000 loan at 6 percent interest, which cannot be traced to the construction of the building.

Analysis:
The building is real property and constitutes an entire unit of designated property.  The accumulated production expenditures are $1,000,000.  The $600,000 loan is traced debt.  Interest of $48,000 ($600,000 x 8 percent) must be capitalized with respect to the traced debt.  The excess expenditure amount is $400,000 (Accumulated production expenditures of $1,000,000 less traced debt of $600,000).  Thus, $400,000 of the $700,000 loan is non-traced debt.  Interest of $24,000 ($400,000 x 6 percent) must be capitalized with respect to the non-traced debt.  Thus, X must capitalize interest in the amount of $72,000 ($48,000 interest on traced debt plus $24,000 interest on non-traced debt).

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Interest capitalization requirements (including the “avoided cost” method) apply to partnerships and other flow-through entities (IRC section 263A(f)(2)(C).  The requirements are applied at the partnership level first and then at the partner level, except as provided in the regulations.  In other words, if the partnership does not have debt equal to or in excess of the accumulated production expenditures, then interest expense incurred by partners may have to be capitalized.

Change in Method of Accounting

If it is determined that a taxpayer is not capitalizing interest and expenses as required by IRC section 263A, then the taxpayer’s accounting method should be changed (IRC sections 481, 446, and related regulations).

Examination Techniques

A thorough explanation of examination techniques is included in Section 263A Uniform Capitalization.

Issue Identification

  1. Other deductions claimed on the partnership return might be costs that are required to be capitalized.
  2. Taxes claimed on the partnership return may include real estate taxes related to the development of real property.
  3. If interest expense is claimed on the partnership return, it may have to be capitalized.

Documents to Request

  1. Partnership Agreement and all amendments.
  2. Copies of all loan documents including, but not limited to promissory notes, deeds of trusts, and mortgages.
  3. All workpapers, schedules, and documents used to determine amount of interest expense deduction
  4. Invoices, receipts and all other documents for “Other” Deductions (consultants, architects, engineers, lawyers, etc.) and real estate taxes.
  5. Settlement sheets and other documents related to the purchase of real property.
  6. Construction and architectural contracts.
  7. Other documents may have to be requested for deductions claimed that appear to be subject to capitalization.

Interview Questions

  1. Did the partnership develop any real estate during the year?
  2. Did the partnership acquire any real property during the year or in prior years?  If yes, what was the purpose for acquiring the property, what was the purchase price, and what is the location of the property?
  3. Did the partnership deduct any costs related to the acquisition and development of real property?  If yes, what was the type and amount of the cost?
  4. Question the partnership on the purpose of deductions claimed for architectural fees, consultants, engineers, etc.
  5. How did the partnership determine its interest expense deduction?
  6. Refer to the guide entitled Section 263A Uniform Capitalization for leads on other possible interview questions.

Supporting Law

IRC section 263A and related regulations

See Treas. Reg. section 1.263A-10 for a series of comprehensive examples of the uniform capitalization rules being applied to various real estate development fact situations.

Von-Lusk v. Commissioner, 104 T.C. 207
Real estate development limited partnership was required to capitalize pre-production costs (real estate taxes, meetings with government officials, costs of obtaining building permits and zoning variances, costs of negotiating permit fees, costs of performing engineering and feasibility studies, drafting and architectural plan costs, etc.)

Lee D. Hustead, T.C. Memo 1994-374
Costs incurred to challenge zoning of property were required to be capitalized.  Also, see Lee D. Hustead, et.ux v. Commissioner, 76 AFTR 2d Par. 95-5112, and Lee D. Hustead, et. Ux. v. Commissioner, T.C. Memo 1997-205-expenses of challenging the constitutionality of local zoning ordinances were required to be capitalized.

John J. Reichel v. Commissioner, 112 T.C. 14
Real estate developer purchased land that was never developed due to adverse economic conditions.  Court required capitalization of real estate taxes even though developer incurred no development costs like taxpayer in Von-Lusk, supra.

Resources

Section 263A Uniform Capitalization, Document 10822 (Rev. 6-98), Catalog No. 25981E

You may also contact the Technical Advisor for Uniform Capitalization.

See Exhibit 8-1
 

Chapter 7 | Table of Contents | Chapter 9

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Page Last Reviewed or Updated: 27-Oct-2014