Kenneth Weil, of the Kenneth C. Weil Law Office, has made available for download his article, “Recourse and Nonrecourse Debt: What Are the Federal Income Tax Consequences When the Character of Debt Changes,” published in The Tax Lawyer, Volume 74 No. 1, 2020. The abstract is as followed:
When encumbered property is sold, the taxation of that sale is different if the sale involves recourse debt as opposed to non-recourse debt. This difference raises an intriguing question: when debt changes from recourse debt to non-recourse debt or vice versa, which rules will control? Examples of when debt changes from recourse to non-recourse or vice versa include bankruptcy discharges, foreclosures in a state with anti-deficiency statutes, some short sales in deficiency states, and the operation of Bankruptcy Code section 1111(b).
The Cottage Savings regulations, Regulation section 1.1001-3, have specific provisions designed to answer the question what happens when debt changes from recourse to non-recourse or vice versa. These regulations are sometimes helpful to creditors, e.g., elections under Bankruptcy Code section 1111(b)(2). Sometimes, they appear punitive to debtors, e.g., the mandatory conversion of recourse debt into non-recourse debt in Chapter 11. And, sometimes, they do not provide an answer, e.g., short sales and foreclosures in some anti-deficiency states.
The author believes that when debt is converted from recourse to non-recourse by operation of the bankruptcy discharge, there should be a discharge of indebtedness event, and thereafter, the non-recourse rules would apply, though with the non-recourse debt reduced by the amount of debt discharged. In other words, after discharge, the non-recourse debt would be reduced to the fair market value of the collateral. Upon a subsequent sale, the amount realized to 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 would no longer apply, i.e., the amount realized would not be the old face value of the debt thereby putting an end to punitive gains under the current non-recourse-sale rules.
Posted by Elise Kim, Managing Associate Editor, Wealth Strategies Journal.