Treatment of Excess Nonrecourse Partnership Debt and COD Income Under Section 108

The U.S. Internal Revenue Service (IRS) has just issued helpful guidance that may allow partners in partnerships whose debt is being cancelled or reduced to avoid or minimize tax on cancellation of debt (COD) income. Guidance issued more than a decade ago left unsettled a crucial tax factor in determining whether a partner in such a situation could take advantage of the insolvency exception to recognition of COD income under section 108(d)(4) of the U.S. Internal Revenue Code of 1986, as amended (the Code). On May 25, 2012, the IRS issued Revenue Ruling 2012-14, which addresses that issue and allows a partner to take into account partnership non-recourse debt when calculating whether such partner is personally insolvent and thus, eligible for this exemption from recognizing COD income.

Prior Guidance

Prior IRS guidance in Revenue Ruling 92-53 addressed the treatment of nonrecourse debt, generally, for purposes of determining whether a taxpayer is insolvent. According to Revenue Ruling 92-53, if nonrecourse debt exceeds the fair market value of property securing the debt, such excess is treated as a liability of the taxpayer to the extent that such excess nonrecourse debt is discharged. For purposes of section 108, a taxpayer could count such liability to determine whether or not the taxpayer qualifies for the insolvency exclusion for COD income.