Debt Relief and Partnership Foreclosure
When a partnership defaults on its debt obligations, its lender will generally foreclose on property securing the loan. During the foreclosure process, the lender seizes whatever asset has secured the loan and attempt to sell it at fair market value (FMV). To the partnership, the foreclosure represents a reduced liability, which will be treated as cancellation of debt (COD) income. How the foreclosure affects the partnership’s tax basis depends on whether the loan is a recourse or non-recourse loan.
For a non-recourse loan, the partnership is treated as if the proceeds of the “sale” were equal to the amount of the debt. As a result, the partnership is not assigned either a profit or a loss. The lender is on the hook for any difference.
For a recourse loan, the partnership is deemed to receive a distribution equal to the lesser of:
• the asset’s fair market value
or
• the amount of the debt
If the debt is less than the asset’s FMV, the partnership will be allocated the amount of the debt and will be credited with zero income. Any income arising from the sale will rightfully belong to the creditor.
If the debt is greater than the value of the foreclosed assets, the partnership will be allocated a COD income equal to the difference. The lender has “recourse” to continue to pursue the remaining deficiency with the borrower. COD income will be allocated to the DPP and distributed to its general partners. If the partnership has held the asset for longer than one year, the partners’ COD income will be taxed at the capital gains rate. Otherwise, it will be taxed as ordinary income.
Example: Freeport, LLC, defaults on its $400,000 mortgage, and its bank finds that the fair market value of the property seized is $300,000. As a limited partner with a 20% share, Deidre’s $80,000 in debt is cancelled. Because the loan is a non-recourse loan, her cancellation of debt income is deemed to be he