Code Section 752 and its regulations provide extensive rules as to determining whether partnership debt is recourse or nonrecourse. Such determinations are relevant for basis determination purposes under Subchapter K (the Subchapter applicable to partnership taxation) and other Subchapter K purposes.
In Chief Counsel Advice, the IRS concluded that, for purposes of determining whether a limited liability company taxed as a partnership has either cancellation of debt (COD) income under Code Sec. 61(a)(12) or gains from dealings in property under Code Sec. 61(a)(3) upon foreclosure of its property, the Code Section 752 rules do not govern whether the debt at issue was recourse or nonrecourse. Instead, the Section 752 rules apply only for Subchapter K purposes.
Why was recourse vs. nonrecourse status relevant? This is because when a taxpayer disposes of encumbered property, and the encumbrance exceeds the value of the property, different tax results apply depending on whether the debt is recourse or nonrecourse. If it is a recourse debt, the amount realized on the sale attributable to the debt is limited so as to bring the amount realized only up to the fair market value of the property. The excess of the recourse debt over the fair market value of the property is treated as COD income. The bad news is that COD income is taxed at ordinary income rates. The good news, sometimes, is that COD income may be avoidable if one of the exceptions under Section 108 apply (relating to when cancellation of indebtedness income need not be recognized).
If the debt is nonrecourse, then the entire amount of the nonrecourse debt is included in the amount realized, and there is no COD income. Here the good news and bad news is flipped – all of the income is eligible for long term capital gains rates (if otherwise applicable based on holding period and character of the asset), but no opportunity for avoidance of COD income under Section 108 applies.
Chief Counsel Advice 201525010
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