Tax Court rules debt cancellation part of sale realization

he Tax Court has held in Parker v. Commissioner (T.C. Memo 2023-104) that an S corporation’s cancellation of nonrecourse debt should be included in the amount realized on the sale of property and is not cancellation of debt (COD) income.

In Parker, an S corporation (Exterra) was wholly owned by an individual (Parker). Exterra held single member LLCs that were treated as disregarded entities (DREs) for federal income tax purposes.

In March 2007, Exterra purchased, through its DREs, a real estate development property in Livermore, Calif. (the “Livermore property”). The purchase was financed with a nonrecourse loan from an unrelated third-party lender, NRFC WA Holdings, LLC (“NRFC”).  Mr. Parker personally guaranteed payment on the third-party loans. In addition, two of the loans were secured by the membership interests in two of Exterra’s DREs (the “Montevina entities”).

In 2012, Exterra sold the Livermore property to third-party buyers. As part of the sale, membership interests in the Montevina entities were also sold to the buyers. The buyers also agreed to assume the personal guaranty obligation loans to NRFC. Exterra realized $40,585,539 upon the assumption of nonrecourse debt by the buyers and $12,698,829 from the debt cancelled by NRFC.

Exterra’s originally filed a return reporting $53,284,369 in gross receipts related to the debt assumed by the buyers and debt cancelled by NRFC. After netting the gross receipts against cost of goods sold and other deductions, Exterra reported $2,741,399 of ordinary business income. Exterra later amended its return to reduce its gross receipts from the Livermore sale by $2,741,399, and instead report that amount as COD income that could be excluded under the insolvency exception of Section 108(a)(1)(B) because Exterra and Mr. Parker were both insolvent at the time of the cancellation of debt. 

The Tax Court held that the Livermore property was encumbered by nonrecourse debt and the outstanding debt should be included in the amount realized under Commissioner v. Tufts (461 U.S. 300 (1983)) and Crane v. Commissioner (331 U.S. 1 (1947)). Under Section 1001(a), Exterra recognized gain to the extent the amount realized exceeded its adjusted basis in the Livermore property. The Court’s decision was based on the fact that the cancellation of the debt was conditioned upon the sale of the Livermore property citing 2925 Briarpark, Ltd. V. Commissioner (163 F. 3d 313 (5^th Cir. 1999)).

The Court held that the insolvency exception can only be applied after establishing that COD income exists, and the cancellation did not result in COD income under Section 61(a)(12).