Many partners in real estate partnerships are lucky enough to receive distributions of cash flow without a corresponding amount of taxable income, due to depreciation and other noncash deductions. Less fortunate partners are allocated taxable income without cash distributions (so-called “phantom income”). A prime example of phantom income is cancellation of debt income (“COD income”) arising from debt discharges. There are several ways for COD income to be excluded from a taxpayer’s gross income, such as if the taxpayer was insolvent at the time of the discharge. The Internal Revenue Service recently issued a new revenue ruling with special tax rules for partnerships that recognize COD income and allocate the income to their partners who are insolvent.
Background
A discharge of indebtedness generally creates COD income that is taxed at ordinary income rates. For example, two partners may each invest $100 in a 50-50 partnership that borrows $800 to acquire land worth $1,000. If the land declines in value and the lender agrees to reduce the $800 of debt to $500 of principal, the partnership recognizes $300 of COD income, and each partner must recognize $150 of ordinary taxable income, unless an exception applies. It is a small consolation that a partner could recognize a $150 loss when he ultimately disposes of his interest in the partnership, because the sale may occur many years later and the loss might be a capital loss.
Insolvency Exclusion
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