## Facts

- Individual A borrowed $1,000,000 from lender C under a nonrecourse note bearing market interest; A had no personal liability.
- The note was secured by an office building that A purchased from seller B for $1,000,000 using the loan proceeds.
- In the following year, the building’s value fell to $800,000 while the outstanding principal remained $1,000,000.
- C (a third-party lender, not the property’s seller) modified the note by reducing principal from $1,000,000 to $800,000; the modified note bore adequate stated interest.
- The facts assume none of the statutory exclusions for discharge of indebtedness (e.g., bankruptcy or insolvency) apply.

## Issues

1. Whether a third-party lender’s reduction of principal on undersecured nonrecourse debt results in discharge of indebtedness income under I.R.C. § 61(a)(12) in the year of the reduction.
2. Whether the same principal reduction instead should be treated as a reduction in the taxpayer’s basis in the property securing the debt.

## Decision

- The principal reduction resulted in discharge of indebtedness income to A under § 61(a)(12) in the year of the modification.
- The principal reduction did not produce a basis reduction in the secured property on these facts.

## Legal Principles

- Gross income includes income from the discharge of indebtedness. (I.R.C. § 61(a)(12); Treas. Reg. § 1.61-12(a))
- A debt’s satisfaction or reduction for less than its stated principal can create ordinary income from discharge of indebtedness, including for nonrecourse obligations, absent a statutory exclusion. (Kirby Lumber rationale as applied in IRS guidance)
- Treatment of nonrecourse debt as part of “amount realized” under the disposition rules does not control a stand-alone debt modification when there is no sale or exchange of the property. (Distinguishing Tufts)
- A purchase-price-adjustment theory is unavailable where the creditor reducing the debt is not the property’s seller; a third-party lender’s reduction is analyzed under discharge-of-indebtedness rules rather than as a basis adjustment. (Consistent with § 108(e)(5) limits)

## Conclusion

A third-party lender’s reduction of undersecured nonrecourse principal, without a disposition of the secured property and without applicable § 108 exclusions, is treated as discharge of indebtedness income under § 61(a)(12) in the year of the reduction, not as a reduction in the property’s basis.


Rev. Rul. 91-31, 1991-1 C.B. 19 (1991)