The IRS announced new taxpayer friendly rules for application of the cancellation of indebtedness income (“CODI”) relief. The announcement was made in an advance copy of Revenue Ruling 2012-14, which will be published on June 11, 2012.
Under the Internal Revenue Code a taxpayer can exclude CODI to the extent the taxpayer was “insolvent” before the cancellation event. The meaning of insolvency was unclear in the context of non-recourse loans. For example, look at A who is a 10% limited partner in Realco, which owns a building worth $20 million, subject to a $25 million non recourse debt. It was unclear whether A’s $500,000 share of the deficiency was his liability for purposes of the insolvency test since personally he was not liable for the debt. The ruling states that he can consider his “share” of this non recourse liability for purposes of determining whether he is insolvent. For example, if A’s assets and liabilities, exclusive of Realco, are even, he would be insolvent for these tax purposes to the extent of $500,000. Therefore, he would not have to report federal income if the loan were restructured in a manner that passed through to him up to $500,000 of CODI.
The ruling may be evidence that the IRS recognizes the pain the real estate industry is experiencing. It applies a liberal reading of the law, not a technical reading that would frustrate the intent to provide taxpayer relief.
We caution that there are still many unanswered questions concerning CODI and each transaction needs to be approached with great care. Also, the ruling does not necessarily help with State income tax issues and it will be of absolutely no help with respect to Philadelphia’s local income taxes.
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