In the current market, many real estate owners continue to struggle as the maturity date approaches for loans on distressed real estate. In one common workout scenario, the lender contributes all or a portion of the outstanding debt to the borrower in exchange for an equity interest in the property. On its face, this transaction might appear to be a simple tax-free contribution to a partnership in exchange for a partnership interest. Unfortunately, this transaction is far from simple, and in many cases will not be tax free. In November, the Internal Revenue Service issued final regulations that provide guidance on (1) the determination of cancellation of indebtedness income of a partnership borrower that issues a partnership interest to its lender in satisfaction of the partnership’s debt, and (2) the tax consequences to the lender. These regulations substantially incorporate proposed regulations issued in 2008, with some helpful modifications, and clarify the tax treatment of this common transaction.

Background

When a lender cancels all or a portion of a borrower’s indebtedness, the borrower generally will have taxable income equal to the amount of the discharge (known as cancellation of indebtedness income, or “COD” income). This is generally true whether the borrower satisfies any reduced amount of debt with cash, or with property. However, prior to 2004, there had been a question as to whether a borrower partnership’s issuance of an interest in the partnership in exchange for satisfaction of its debt was tax free to the partnership in cases where the partnership interest was worth less than the face amount of the debt.

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