Recourse and Nonrecourse Debt: What Are the Federal Income Tax Consequences When the Character of Debt Changes

Abstract

When encumbered property is sold, the taxation of that sale is different if the sale involves recourse debt as opposed to nonrecourse debt. This difference raises an intriguing question: when debt changes from recourse to nonrecourse, or vice versa, which rules will control? Examples of when debt changes from recourse to nonrecourse, or vice versa, include bankruptcy discharges, nonjudicial foreclosures in some states with deficiency statutes, some short sales in deficiency states, and the operation of section 1111(b) of the Bankruptcy Code.

The Cottage Savings regulations, Regulation section 1.1001-3, have specific provisions designed to address what happens when debt changes from recourse to nonrecourse, or vice versa. These regulations are sometimes helpful to creditors (e.g., elections under section 1111(b)(2) of the Bankruptcy Code). Sometimes, they appear punitive to debtors (e.g., the mandatory conversion of recourse debt into nonrecourse debt in Chapter 11). And, sometimes, they do not provide an answer (e.g., short sales and nonjudicial foreclosures in deficiency states).

The Author believes that when recourse debt is converted to nonrecourse debt by operation of a discharge in bankruptcy, there should be a discharge of indebtedness event, and thereafter, the nonrecourse rules would apply, albeit with the nonrecourse debt reduced by the amount of the debt discharged. As a result, after discharge, the nonrecourse debt would be reduced to the fair market value of the collateral. Upon a subsequent sale, the amount realized by the debtor would be the fair market value of the property (or the new tax-value of the debt if the property declines in value). The current rule, with the amount realized equaling the old face value of the debt, would no longer apply. This change would put an end to the punitive gains resulting from the current nonrecourse-sale rules. Unfortunately, this proposal is probably not administratively feasible.

I. Introduction

When encumbered property is sold, the federal income taxation of that sale is different if the sale involves recourse debt as opposed to nonrecourse debt. This difference raises an intriguing question: when debt changes from recourse to nonrecourse, or vice versa, which rules will control? Examples of when debt changes from recourse to nonrecourse, or vice versa, include bankruptcy discharges, nonjudicial foreclosures in some states with deficiency statutes, some short sales in deficiency states, and the operation of section 1111(b) of Title 11 of the United States Code (Bankruptcy Code).

This Article addresses the application of these rules in four parts. Part II provides a primer on federal income taxation of debt relief. It distinguishes the rules for debt relief by forgiveness versus debt relief by sale or exchange. As to transactions involving a sale or exchange, it distinguishes the tax treatment of recourse debt from nonrecourse debt. Part III turns to events that can change the character of debt from recourse to nonrecourse, or vice versa. Part IV looks at specific statutes and regulations that deem a sale or exchange of a debt instrument to have occurred. Part V applies the rules found in Parts II, III, and IV to the character-changing transactions.

II. Debt Relief Primer

There are two types of debt relief. One type is debt relief by forgiveness, often called cancellation of debt (COD). COD produces discharge of indebtedness income, often referred to as COD income. An example of COD income is forgiveness of credit card debt. The other type of debt relief is tied to the sale of an asset that was purchased with borrowed funds, such as a personal residence. Assume that as a result of the sale, the taxpayer no longer owes the mortgage debt. That debt can be eliminated in one of two ways. The first way is by payment of the debt in full using the proceeds of the sale. The income tax consequences of such a sale are governed by the rules of section 1001 of the Internal Revenue Code. Because the debt is paid in full, there is no COD and no COD income. The second way is for a portion of the debt to be forgiven as part of the sale transaction, either by the lender or by operation of law. For example, if the sale proceeds are insufficient to repay the debt in full, the lender could forgive payment of the remainder of the debt. If the debt is recourse, the portion of the debt that is forgiven will be treated as COD income. If the debt is nonrecourse and forgiven by operation of law, the unpaid portion of the debt will be treated as part of the taxpayer’s amount realized under section 1001.

A. COD Is a Taxable Event

When money is borrowed, there is no accession to wealth. The borrower has the economic benefit of additional liquidity, but there is no change in net worth. The new liability offsets the new asset. If that borrowing is subsequently forgiven, there is income. Since 1931, it has been clear that COD creates income, and that income is subject to tax.

Congress has tempered the COD income rules with a number of statutory exclusions under section 108 of the Internal Revenue Code. These rules apply only to COD income. They do not apply to debt paid as part of the amount realized in a sale or exchange of encumbered property.

One statutory exclusion provides, in essence, that if the borrower is insolvent both before and after the COD, then the borrower can exclude the COD from income. The statutory price for the exclusion is a reduction of certain specified tax attributes. The policy reason for this exclusion is that “broke is broke,” and the taxpayer should not be deemed to have an accession to wealth to the extent the discharge does not render the taxpayer solvent. Another statutory exclusion covers COD income generated by operation of Title 11 of the Bankruptcy Code. The exclusion for COD income generated in bankruptcy is broader than the insolvency exclusion and reflects the congressional decision that the federal income tax should not undercut the “fresh start” purpose of the federal bankruptcy law.

B. Debt Relief as a Part of the Sale or Exchange of Property

The Internal Revenue Code defines gain from the disposition of property as the excess of the “amount realized” (AR) over the “adjusted basis” (AB). Debt is included in AB upon purchase. This forces a parallel rule that the funds used to pay off that debt upon sale, whether cash payment with proceeds received from the buyer or deemed payment by debt relief, are included in the AR. This rule is a tax-policy decision made in the early years of the federal income tax. Inclusion of the borrowed funds in the AB increases the available depreciation and puts those that borrow to purchase on a similar footing with those that pay cash. This rule also makes the amount of gain on sale identical between borrowers and cash-only purchasers. For example, if a taxpayer purchases a nondepreciable asset for $100, using $10 in cash and $90 borrowed from a third-party lender, the taxpayer’s AB is $100 under Crane v. Commissioner. Subsequently, before having repaid any of the $90 borrowed from the lender, the taxpayer sells the property to a buyer for $120. Taxpayer’s AR is $120, even though the taxpayer must use $90 of the $120 to repay the $90 owed to the lender. The taxpayer’s taxable gain is $20 ($120 AR – $100 AB). Had the taxpayer purchased the property using $100 in cash, the result would be identical: AB of $100, AR of $120, and taxable gain of $20.

C. Sales of Property with Recourse or Nonrecourse Debt

Treasury Department regulations establish rules for the tax treatment of COD income upon the sale or other disposition of an asset. Under these rules, the tax treatment of COD income when the debt is recourse is different from the tax treatment of COD income when the debt is nonrecourse. This difference in tax treatment creates challenging problems, especially when existing recourse debt becomes nonrecourse debt, or vice versa.

As a first step, one must understand the difference between recourse and nonrecourse debt. If the debt is “recourse,” the creditor has the right to satisfy the claim from the property that secures the debt as well as from the debtor’s other assets and income. If debt is “nonrecourse,” the creditor is limited to satisfying the claim from the property that secures the debt.

1. The Tax Treatment of Recourse Debt Upon Disposition of an Encumbered Asset

When the disposition of an encumbered asset involves the discharge of recourse debt, the transaction is bifurcated for tax purposes. For example, assume that a taxpayer purchases nondepreciable property for $80, paid entirely with a recourse loan from a lender. Assume further that when the property has a fair market value of $100, the taxpayer borrows an additional $20, on a recourse basis, from the lender for a total of $100. The taxpayer does not use the additional $20 to acquire or improve the property. Both the $80 loan and the $20 loan are recourse, require the payment of interest only, and all interest is timely paid. Subsequently, when the property has declined in value to $70, the taxpayer sells the property to the lender for $70, and the lender discharges the remaining $30 of debt as part of the sale. The taxation of this transaction involves a two-step process.

Step 1

$ 70 AR, which is limited to the fair market value of the property at time of the sale

$ –80 AB, which is the original purchase price

$ –10 Loss realized under section 1001.

Step 1 involves the disposition of property under section 1001 of the Internal Revenue Code, not the discharge of indebtedness.

Step 2

The $30 excess of the debt ($100) over the fair market value of the property ($70) is treated as COD income, and the COD income ($30) is eligible for exclusion under the rules of section 108 of the Internal Revenue Code.

2. The Tax Treatment of Nonrecourse Debt Upon Disposition of an Encumbered Asset

When the disposition of an encumbered asset involves the discharge of nonrecourse debt, the transaction is not bifurcated for tax purposes. For example, assume again that a taxpayer purchases nondepreciable property for $80, paid entirely with a nonrecourse loan from a lender. When the property has a fair market value of $100, the taxpayer borrows an additional $20, on a nonrecourse basis, from the lender for a total of $100. The taxpayer does not use the additional $20 to acquire or improve the property. Both the $80 loan and the $20 loan are nonrecourse, require the payment of interest only, and all interest is timely paid. Subsequently, when the property has declined in value to $70, the taxpayer sells the property to the lender for $70. The taxation of this transaction is not bifurcated.

$ 100 AR, which is the amount borrowed

–$ 80 AB, which is the original purchase price

$ 20 Gain realized under section 1001.

The $20 gain is gain from the disposition of property and not COD income, which means that the special exclusion rules of section 108 do not apply.

3. Which Treatment Is Better for the Taxpayer?

Whether a taxpayer fares better with recourse or nonrecourse debt upon sale depends on the nature and character of the asset sold and whether any COD income is eligible for exclusion under section 108 of the Internal Revenue Code. For example, if the property in the above examples is a personal residence, nonrecourse treatment is likely to be preferred because of the generous exclusion rules for gain incurred on the sale of a personal residence. If the property is not a personal residence but the taxpayer remains insolvent after the disposition, the taxpayer may prefer the recourse rules, provided there is no tax attribute reduction.

III. The Metamorphosis: Conversion of Recourse Debt to Nonrecourse Debt, or Vice Versa

There are at least four instances in which recourse debt is converted into nonrecourse debt, or vice versa: (1) some nonjudicial deed-of-trust foreclosures in Washington state, (2) short sales in a deficiency state where the creditor releases the debtor from further liability or the debtor is released by operation of law, (3) discharges in Chapter 7 cases under the Bankruptcy Code, and (4) by operation of the rules under section 1111(b) of the Bankruptcy Code.

A. Washington State Nonjudicial Deed-of-Trust Foreclosures

Under Washington state’s anti-deficiency rules, subject to special rules for commercial loans, a nonjudicial deed-of-trust foreclosure bars further collection by the foreclosing creditor. If a nonjudicial foreclosure occurs, the deed of trust “enters” the world as a recourse debt instrument and “exits” as a nonrecourse instrument.

While the Author is unsure of the number of anti-deficiency states, such statutes are prevalent in the western portion of the United States. The scope of the rules vary by state. For example, in California, even beyond its general anti-deficiency rule for nonjudicial deed-of-trust foreclosures, an anti-deficiency rule applies to all single-family homeowners (among others) with purchase money debt, whether a first, second, or third position lien, and to all refinancings by a single-family homeowner (among others) of any purchase money debt after December 31, 2012. The anti-deficiency rules do not apply to refinancings made before January 1, 2013. In Oregon, the anti-deficiency protection applies from the inception of the loan and applies regardless of any refinancing. The Washington rules differ from the California and Oregon rules in another, major aspect. In Washington, if there is a first and a second lien on the property and the holder of the first lien forecloses through a nonjudicial deed of trust, the debtor remains personally liable on the second lien.

B. Short Sales in a Deficiency State

Some short sales can create a fact pattern very similar to the Washington state nonjudicial deed-of-trust foreclosure. If the debtor is in a deficiency state and the creditor releases the debtor from any additional liability after the short sale closes, the debt instrument “enters” the world as a recourse debt instrument and “exits” as a nonrecourse instrument.

California added a special rule in the California Code of Civil Procedure, which provides that single-family homeowners (among others) cannot have a deficiency taken against them on a short sale. Thus, in a California short sale, pre-2013 refinanced debt on a personal residence “enters” the world as recourse debt and “exits” as nonrecourse debt.

C. Chapter 7 Discharges

Recourse debt enters bankruptcy as recourse debt. Upon entry of an order of discharge, the recourse debt is converted to nonrecourse debt. After entry of the order of discharge and abandonment of the collateral by the bankruptcy estate, the secured creditor can collect against any collateral securing the debt, but further collection efforts against the debtor personally are barred.

D. Section 1111(b) of the Bankruptcy Code

Section 1111(b) of the Bankruptcy Code has two rules, one under section 1111(b)(1)(A) and the other under section 1111(b)(2), that can change debt from recourse to nonrecourse, or vice versa. Once the new section 1111(b) loan terms are in place and a plan is confirmed, the new loan terms apply. Section 1111(b)(1)(A) operates automatically. Section 1111(b)(2) requires an election.

1. Section 1111(b)(1)(A) of the Bankruptcy Code

Under section 1111(b)(1)(A), a secured creditor holding nonrecourse debt is granted a secured claim the same as if the creditor had recourse against the debtor. This rule provides an “end-run” around section 502(b)(1) of the Bankruptcy Code, which disallows a claim to the extent it is not enforceable under nonbankruptcy law. In the absence of section 1111(b)(1)(A), the creditor would have a claim limited to the value of the property, and section 502(b)(1) would disallow the creditor’s claim for any portion of the debt that exceeds the value of the property.

Section 1111(b)(1)(A) allows a class of nonrecourse creditors (or a single nonrecourse creditor if the collateral securing such creditor’s claim is to be sold under a Chapter 11 plan of reorganization or in a sale under section 363 of the Bankruptcy Code) to participate under the plan as both a secured creditor and an unsecured creditor. In other words, the nonrecourse debt is converted to recourse debt.

For example, assume section 1111(b)(1)(A) applies and the nonrecourse debt totals $10 and the property securing the debt is worth $4. The nonrecourse creditor would have a secured claim of $4 and an unsecured claim of $6. Under the operation of section 1111(b)(1)(A), the $10 debt is now recourse debt, as the creditor can receive money from the debtor over and above the value of the property securing the debt.

2. Section 1111(b)(2) of the Bankruptcy Code

If the secured creditor makes an election under section 1111(b)(2) of the Bankruptcy Code, the claim is secured to the extent the claim is allowed. This rule provides an “end-run” around section 506(d) of the Bankruptcy Code, which limits secured claims to the value of the property. Under the operation of section 1129(b)(2)(A)(i)(I) and (II) of the Bankruptcy Code, the creditor retains the lien in the allowed amount of the claim, and the creditor receives payments, using present value analysis, that equal the value of the lien at the plan confirmation date.

For example, assume that the debt owed is $10, and the property is worth $4. The debtor’s plan must provide for (1) total payments of $10, which include both principal and interest payments, and (2) the present value of the total payments must be at least $4. The net result of this election is that, if the property is sold before the claim is paid in full, the secured creditor can receive the benefit of any appreciation in the property, at least up to the value of the claim of $10. Any interest received between plan confirmation and sale counts toward the $10. After the sale, if the $10 claim has not been paid in full, the creditor has no further recourse against the debtor.

A creditor would make this election if the creditor thought that the property appreciation would be larger than any distributions for unsecured creditors anticipated under the plan. The creditor who makes a section 1111(b)(2) election waives the right to be paid as an unsecured creditor on the deficiency claim and waives the right to vote with unsecured creditors. As a result of the section 1111(b)(2) election, the debt is now essentially nonrecourse debt, as the creditor’s recovery is limited to the lesser of the claim or the value of the property when it is sold.

IV. Deemed Sales or Exchanges

A termination of a debt instrument under section 1271 of the Internal Revenue Code or a substantial modification of a debt instrument under Regulation section 1.1001-3 creates a taxable event that is deemed a sale or exchange. Section 108(e)(10)(A) of the Internal Revenue Code also provides rules for debtors when debt instruments are exchanged.

A. Section 1271 of the Internal Revenue Code

Under section 1271(a)(1) of the Internal Revenue Code, “[a]mounts received by the holder on retirement of any debt instrument shall be considered as amounts received in exchange thereof.” This means that for tax purposes amounts received in retirement of a debt instrument are treated under the sale or exchange rules of section 1001 and not the bad-debt loss-deduction rules of section 166.

“Neither the statute nor the regulations define the meaning of the term retirement.” In McClain v. Commissioner, the Supreme Court wrote:

In common understanding and according to dictionary definition the word “retirement” is broader in scope than “redemption”; is not, as contended, synonymous with the latter, but includes it. Nothing in the legislative history of the provision requires us to attribute to the term used a meaning narrower than its accepted meaning in common speech.

In McClain, the taxpayer received less than full payment of the debt. The debt was extinguished, and this seems to be an easy case.

Presumably, notes that are retired due to a short sale or foreclosure would be governed by section 1271.

B. Regulation Section 1.1001-3

The Treasury Department and the Service published Regulation section 1.1001-3 in response to the Supreme Court’s decision in Cottage Savings Association v. Commissioner. As a result, the regulations are often called the Cottage Savings regulations. In that case, Cottage Savings exchanged a package of 252 participation interests in home mortgages for a package of 305 different participation interests. Cottage Savings wanted to realize its loss for tax purposes, and the Service objected. In holding for the bank, the Supreme Court concluded that the exchange of participation interests was a taxable event “so long as their respective possessors enjoy legal entitlements that are different in kind or extent.” Under the Cottage Savings test, it takes very little change in the terms of a debt instrument to trigger a taxable event. Under that test, it is pretty clear that the exchange of a recourse instrument for a nonrecourse instrument would be a change in legal entitlements and a taxable event. The Cottage Savings regulations are an attempt to define the phrase “difference in kind or extent,” so as to narrow the application of Cottage Savings.

Regulation section 1.1001-3 provides a specific set of rules to determine whether a change in status from recourse to nonrecourse, or vice versa, will be considered a taxable event. These rules are parsed below.

• Regulation section 1.1001-3(b). A “significant modification” of a debt instrument results in a sale or exchange.
• Regulation section 1.1001-3(c)(1)(i). “A modification means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise.” A modification includes a change from recourse to nonrecourse, or vice versa, or change in obligor.
• Regulation section 1.1001-3(e)(1). Except as otherwise provided, “a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.”
• Regulation section 1.1001-3(e)(5)(ii)(A). This is one of the except-as-otherwise-provided exceptions of Regulation section 1.1001-3(e)(1). “Except as provided in paragraph (e)(5)(ii)(B) of this section, a change in the nature of a debt instrument from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse) is a significant modification.” A change from nonrecourse to recourse is also a significant modification.
• Regulation section 1.1001-3(e)(5)(ii)(B)(2)(i). “A modification that changes a recourse debt instrument to a nonrecourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations.” This very specific provision applies only to a change from recourse to nonrecourse.
• Regulation section 1.1001-3(e)(4)(vi). A change in payment expectations occurs if (1) the obligor’s capacity to pay is enhanced because prior to the modification the capacity to pay is speculative, and after the modification the capacity to pay is adequate, or (2) the obligor’s capacity to pay is impaired because prior to the modification the capacity to pay was adequate, and after the modification the capacity to pay is speculative.

Under the Cottage Savings regulations, when debt changes from recourse to nonrecourse, the key issue is whether the modification results in a change in payment expectations. The regulations appear to command a “just before” and “just after” analysis. Because this inquiry will be fact intensive, there will be no automatic answers. For example, in the bankruptcy context, a pre-bankruptcy change, such as the first default or a precipitous decline in collateral value, may be the event that results in a change in payment expectations. In that scenario, the change from recourse to nonrecourse (i.e., the entry of the bankruptcy discharge) may have no impact on payment expectations. Or, the bankruptcy discharge itself may result in improved payment expectations, as the debtor’s unsecured debt disappears and funds may now be available to pay the secured creditor. Or, payment expectations may worsen as a result of the bankruptcy discharge, as the creditor loses the ability to pursue the debtor’s other property.

Changes in loan terms under the Bankruptcy Code section 1111(b)(2) election, which is a change from recourse to nonrecourse debt, should almost always result in a change in payment expectations. Unlike debt that goes from recourse to nonrecourse, the Cottage Savings regulations do not have an exception from sale or exchange treatment if the debt goes from nonrecourse to recourse. This means a taxable event will be triggered when section 1111(b)(1)(A) of the Bankruptcy Code applies, as that provision provides for the change of debt from nonrecourse to recourse.

C. Section 108(e)(10)(A) of the Internal Revenue Code

If a significant modification results in a taxable event to the debtor, how is this taxable event treated by the debtor? Section 108(e)(10)(A) of the Internal Revenue Code provides guidance:

For purposes of determining income of a debtor from discharge of indebtedness, if a debtor issues a debt instrument in satisfaction of indebtedness, such debtor shall be treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument.

As an example of the application of section 108(e)(10)(A), assume the debtor is an individual who receives a discharge in a case under Chapter 7 of the Bankruptcy Code. The debtor has investment property that is encumbered with recourse debt that exceeds the fair market value of the property, and the bankruptcy trustee abandons the property at the end of the case. For tax purposes, the old recourse debt is deemed exchanged for new nonrecourse debt. If the Cottage Savings regulations lead us to a taxable event (i.e., the discharge results in a substantial change in payment expectations), the COD income, if any, is determined under section 108(e)(10)(A). Because the COD arises in bankruptcy, it will be excluded from income. The speculation in Part IV.B notwithstanding, a change in payment expectations at the end of a Chapter 7 case is unlikely, and accordingly, there will not be a taxable event under the Cottage Savings regulations.

Continuing with this example but now assuming that a taxable event occurs, the issue price of the debtor’s new debt instrument is calculated under the original issue discount (OID) rules and is generally the stated principal amount (assuming, as is done in the remainder of this Article, that the applicable instrument is not publicly traded and has adequate stated interest). This means no COD income, as the old stated price and the new stated price are identical. In contrast, under Chapter 13 of the Bankruptcy Code, unless the plan provides for full payment of debt, the old stated price and the new stated price will be different, and there will be COD income. Furthermore, the COD income arises when the plan is confirmed, which is when the substantial modification occurs. There is no guidance on how to return to the status quo ante if the Chapter 13 plan fails and the debt is not discharged.

When a debt instrument does not provide for adequate stated interest, the OID rules provide that the issue price of the debt instrument is the imputed principal amount and not the stated principal amount. In a “potentially abusive situation,” the imputed principal amount of the new debt instrument received in exchange for property is the fair market value of the property involved in the transaction. A debt-for-debt exchange (i.e., recourse to nonrecourse, or vice versa) should be outside the boundaries of this rule, as this rule requires a debt instrument exchanged for property.

In the unlikely event that an individual debtor were to fit into the prohibited transaction rules, these rules would put the individual debtor in a more logical place, which is that the debt instrument is equal in value to the fair market value of the property. Any subsequent disposition of the property would be taxed as a nonrecourse transaction, and to the extent the value of the property rises, there would be sales or exchange gain. If the value of the property declines, the amount realized would be capped at the fair market value of the property at the time of the conversion of the debt from recourse to nonrecourse. That result makes sense. It matches the tax consequences with the economics of the transaction. To the extent the debt exceeds the value of the property, because of the bankruptcy discharge, it is no longer collectible. The COD is then subject to the rules of sections 61(a)(11) and 108 of the Internal Revenue Code. Any subsequent gain or loss would be tied to a change in the value of the property.

V. Application of Law to Facts

This Part applies the previously discussed rules to situations in which debt changes from recourse to nonrecourse, or vice versa. For purposes of analyzing these situations, assume that the debtor holds property with an AB of $80 and a fair market value of $70, and debt of $100 (“hypothetical facts”). Whether the debt is recourse or nonrecourse is set forth in each discussion.

A. Washington State Nonjudicial Deed-of-Trust Foreclosures and Short Sales with a Release of Liability

Consider first Washington state nonjudicial deed-of-trust foreclosures and short sales in deficiency states with a release of liability. Assume that the debt is considered recourse when created and is retired as a result of the foreclosure or short sale. As described above, the creditor has a taxable event under section 1271 of the Internal Revenue Code.

Revenue Ruling 90-16 appears to apply in this situation. In that Ruling, the Service addressed a transaction that was closely akin to a short sale. The taxpayer surrendered the property to the bank, which in turn released the taxpayer from further liability (as opposed to a short sale in which the property is sold to a third party and the debtor is released from further liability). As set forth in the Ruling, the $12,000x debt was recourse, the basis of the property securing the debt was $8,000x, and the fair market value of the property was $10,000x. In satisfaction of the $12,000x liability, the debtor surrendered the property to the bank. The Service treated the surrender of the property as a recourse transaction and bifurcated the transaction into (1) a sale and (2) a discharge of indebtedness. The sale produced $2,000x of recognized gain ($10,000x AR – $8,000x AB). The cancellation of the excess $2,000x of debt produced COD income of $2,000x ($12,000x debt – $10,000x FMV of the property).

The Ruling addressed, in an almost throwaway line and without referencing Washington state law, how a Washington state nonjudicial deed-of-trust foreclosure should be taxed:

If the subdivision had been transferred to the bank as a result of a foreclosure proceeding in which the outstanding balance of the debt was discharged (rather than having been transferred pursuant to the settlement agreement), the result would be the same.

The Ruling concludes that the transaction is bifurcated, which means that the debt is treated as recourse. Under the hypothetical facts, the taxpayer would have a $10 loss on the sale of the property and $30 of COD income.

In 2013 and 2014, a series of letters were sent between the Service and California Senator Barbara Boxer’s office. In essence, the letters acknowledge that short sales under California’s anti-deficiency rules would be treated as nonrecourse sales. In one of the letters, the Service acknowledged that some California refinancing debt remained recourse debt and that treatment of such debt would be different. California now essentially has a nonrecourse rule, except for its small remaining slice of recourse debt. Presumably, Ruling 90-16 applies to the recourse debt, and the nonrecourse rules apply to the nonrecourse debt.

B. Discharge in Chapter 7

Next, consider a bankruptcy discharge when the debt is converted from recourse to nonrecourse. In the normal event of no change in payment expectations, neither the creditor nor the debtor will have a taxable event under the Cottage Savings regulations. One would expect most creditors to prefer the discharge to be a taxable event in order to accelerate their losses, which would likely be ordinary, at least for banking institutions.

With respect to the debtor, because there is no taxable event, there is no COD income. This may seem counterintuitive because the personal liability of the debtor has been discharged. Yet, the now nonrecourse debt remains in existence and is legally enforceable. Not only does the debt remain in existence, under the nonrecourse rules, it is included in the debtor’s amount realized upon a subsequent sale. The debt cannot be both discharged in the bankruptcy and subject to the rules of sections 61(a)(11) and 108 of the Internal Revenue Code and still exist so it is again taxed as part of amount realized when the property is sold. There is no COD income upon entry of the bankruptcy discharge. The debt remains on the debtor’s balance sheet both before and after the bankruptcy discharge is entered.

The better rule would be for (1) the debt to be treated as COD income when the bankruptcy discharge is entered in an amount equal to the difference between the amount of the debt and the fair market value of the property and (2) any subsequent gain or loss determined based upon any subsequent gain or loss in the value of the underlying property subject to the debt. Using the hypothetical facts, the COD income would be $30, the AB would remain $80, and the nonrecourse debt would be reduced to the FMV of the property, $70. If the value of the property increased thereafter and the property were subsequently sold, there would be gain on the sale. If the value of the property decreased further, the amount realized under the nonrecourse rules would still be $70.

In a Private Letter Ruling, the Service found correctly that, in the bankruptcy situation, the conversion of the debt from recourse to nonrecourse by act of the bankruptcy discharge converted the underlying debt instrument to a nonrecourse instrument. Unfortunately, the ruling’s analysis of how COD income works under the applicable facts is incorrect. In the ruling, the taxpayer owned a farm and filed for bankruptcy. The bankruptcy trustee abandoned the farm, and it was returned to the taxpayer. The taxpayer received a bankruptcy discharge. At the time the taxpayer requested the letter ruling, the lender had not foreclosed, and the taxpayer remained in possession of the farm and continued to farm. The Service opined correctly that a subsequent foreclosure of the farm would be treated as a nonrecourse transaction, as the bankruptcy filing had converted the debt on the farm from recourse to nonrecourse. The letter ruling erred in assuming that the taxpayer had COD income when the debtor’s personal liability was discharged by the bankruptcy. The letter ruling provided no analysis of how the debt could be discharged and subject to taxation as COD income, yet remain in existence and be taxed on sale.

C. Section 1111(b) of the Bankruptcy Code

If section 1111(b) of the Bankruptcy Code operates to change the terms of a loan, whether by operation of section 1111(b)(1)(A) or by an election under section 1111(b)(2), the creditor has a taxable event under section 1271 of the Internal Revenue Code or Regulation section 1.1001-3. Under section 1111(b)(1)(A), the debt changes from nonrecourse to recourse and a taxable sale or exchange is deemed to have occurred. Under the section 1111(b)(2) election, the debt is substantially modified and changed from recourse to nonrecourse. Because the section 1111(b)(2) election operates to change the terms of a loan, there will almost always be a change in payment expectations.

The tax consequences to the nonrecourse debtor under section 1111(b)(1)(A) may be severe. There may be significant sale or exchange gain, whether from depreciation recapture or the recognition of gain because of a loan refinancing. Using the facts of the prior example illustrating the operation of section 1111(b), if the amount of the debt were $10, the current fair market value of the collateral $4, and the basis of the collateral $3, either because of depreciation or a prior refinancing, then the debtor would have sale or exchange gain of $7, which is the AR of $10 less the AB of $3.

Under the section 1111(b)(2) election, there is probably some COD income. The prior debt is replaced with a right to receive payments of principal and interest equal to the amount of the old debt but with a present value equal to the current value of the collateral. Again, using the facts of the prior example (i.e., debt of $10 and collateral with a current fair market value of $4 and a basis of $3) and assuming an estimated net present value of the proposed principal and interest payments of $4 and new debt with a stated principal amount of $4, the debtor would realize COD income of $6 on the initial election, which would be excludible under section 108 of the Internal Revenue Code. Thereafter, a sale of the property for anything equal to or less than $4, which is the fair market value of the collateral on the date of the conversion of the debt from recourse to nonrecourse, should result in $1 sale or exchange gain under the nonrecourse debt rules.

VI. Conclusion

This Article examines the taxation of debt when it changes from recourse to nonrecourse, or vice versa. The Cottage Savings regulations fall short of answering all questions, and some of the apparent answers are punitive to debtors. While the Cottage Savings regulations may work efficiently in large corporate settings, they are not as well thought out for individual debtors.

As Justice O’Connor stated in Tufts, “were we writing on a clean slate . . . I would take quite a different approach.” A debtor should not incur Tufts nonrecourse gain because of a bankruptcy filing. Similarly, debtors should not automatically incur Tufts nonrecourse-sale or exchange gain when section 1111(b)(1)(A) of the Internal Revenue Code applies. In the Chapter 7 discharge context when property is abandoned by the bankruptcy estate, COD income should be the difference between the face value of the debt and the fair market value of the collateral. When the debtor disposes of the property after the conclusion of the bankruptcy, the amount of the nonrecourse debt for tax purposes would be the fair market value of the property at the time the discharge was entered. Although this proposal is fair to debtors, it is probably not administratively feasible. The fact-intensive inquiry needed to determine fair market value would make administration by the Service difficult. Furthermore, creditors would have to track two different numbers. One would be the original debt amount, as adjusted for interest and payments. This would be the legally collectible debt. The other would be the creditor’s tax-cost basis, as adjusted for interest and payments, after the debt were written down.