Non-Recourse Debt Forgiveness Bites Shareholder Upon Forgiveness

How is relief of debt treated for tax purposes? Does it matter if the debt is recourse or non-recourse? Does it matter if the debtor is a separate entity guaranteed by the owner(s)? Does it matter if the debt is forgiven as part of a sale of property securing the debt? These issues were addressed in a recent case decided by the Tax Court.[1] The case involved the sale of real property owned by an S corporation and associated discharge of indebtedness which was nonrecourse to the S corporation but personally guaranteed by the 100% shareholder.[2]


Exterra Realty Partners, LLC (“Exterra”), taxed as an S corporation[3], was in the real property development business. Exterra was owned 100% by Michael G. Parker (“Parker”). One of the property interests owned by Exterra was real estate in Livermore, CA, acquired in 2007. Exterra’s acquisition of the Livermore property was financed through multiple loans. Although not the subject of this writing, these loans were a mix of senior and mezzanine debt. The debt was nonrecourse to Exterra, but personally guaranteed by Parker.

In 2012, Exterra entered into several legal agreements related to the sale of the Livermore property for nominal consideration. At the same time, Exterra entered into agreements with its lender to forgive debts in excess of amounts paid, guaranteed, and/or assumed by the buyer. The relevant agreements with the lender stated: “In connection with the proposed sale by [Exterra] of all of [Exterra’s] interest[s] in [the Livermore property], [Exterra] and [its lender] have agreed to terminate the Loan Documents on the terms, and subject to the conditions, set forth herein.”

After the sale and debt forgiveness transactions closed, Exterra filed its income tax return for 2012 reporting approximately $53 million in gross receipts, inclusive of the amount of debt forgiven by the lender or assumed by the buyer. Exterra reported taxable ordinary income, after offsets, of $2,741,399. This amount was passed through to Parker on Exterra’s Schedule K-1 which he reported as income. Subsequently, both Exterra and Parker filed amended returns showing the previous amount included in income as exempt discharge of indebtedness income due to application of an insolvency exception.[4] The IRS challenged these amended returns arguing that there was no discharge of indebtedness income, but rather income from amounts realized on the sale of the Livermore property.


As a broad concept, “all income from whatever source derived”[5] is taxable income, including income from the discharge of indebtedness,[6] unless an exception applies. One such exception applies to insolvent taxpayers. When a taxpayer is insolvent, that taxpayer may exclude income from a discharge of indebtedness up to the amount by which the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets.[7]

When a taxpayer sells property, the amount realized includes “the sum of any money received plus the fair market value of the property” received by the taxpayer in the sale.[8] Specifically, “the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition” (emphasis added).[9] Here, there is a distinction between how recourse and nonrecourse debts are treated for this purpose. A debt is nonrecourse if the creditor’s remedies are limited to collateral, but recourse when the creditor’s remedies extend to the debtor’s other assets.[10]

  • Nonrecourse Debt. When a taxpayer sells property encumbered by nonrecourse debt, the sale of that property is deemed to discharge the taxpayer from the debt.[11] As such, the amount of such discharged debt is included in the amount realized on the sale.[12]
  • Recourse Debt. On the other hand, the amount realized from the sale of property encumbered by recourse debt does not include the amount of the recourse debt unless assumed by the buyer.[13]

A reason for this distinction is that, when the property securing nonrecourse debt is sold, the debtor is no longer liable for the obligation. However, when property securing recourse debt is sold, the debtor remains liable to the lender unless such debt is assumed as part of the transaction. Based on this, when property is sold and there is a relief from debt as a result of such sale, then the resulting income is considered an amount realized from the sale rather than as a forgiveness of indebtedness.[14] In that case, the insolvency exception for gain resulting from discharge of indebtedness cannot apply. On the other hand, if there is a relief from indebtedness independent of the sale of property securing the debt, then the resulting income is treated as discharge of indebtedness income for which the insolvency exception may apply.

In this analysis, a key consideration is whether the discharge of nonrecourse debt was “as a result of” the property sale. If not, then Exterra’s and Parker’s amended returns may correctly apply the insolvency exception. If so, then no such exception applies. Here, the Tax Court looked at all facts and circumstances. Agreements with the lender were signed the same day as the agreements with the buyer of the Livermore property. Further, the legal agreements with the lender included a recital regarding the discharge of debt with the phrase “In connection with the proposed sale.” Due to these and other facts, the Tax Court concluded the nonrecourse debt relief was “as a result of” the property sale.

One issue the Tax Court raised from Parker’s arguments relates to the identity of the taxpayer when determining the recourse or nonrecourse nature of the debt. While it was not completely clear from the Tax Court’s opinion, it appears that Parker argued the debt should be treated as recourse debt due to his personal guarantees. The court addressed this “misconception” by noting that the relevant taxpayer is Exterra, not Parker. It may be true that Exterra, as an S corporation taxed as a passthrough entity, does not pay income tax. Rather, tax on Exterra’s income is paid by Parker. However, the court will “respect Exterra’s separate corporate existence.”[15] Therefore, since Exterra’s assets were not at risk for the liabilities beyond the collateral for the debts (stipulated to by the parties), the liabilities were treated as nonrecourse notwithstanding Parker’s personal guarantees.


Once the Tax Court determined that the debt was nonrecourse debt deemed to be part of the amount realized from the sale of the Livermore property, then it concluded the insolvency exception could not apply. Therefore, the $2,741,399 of income originally reported was taxable in the year of the sale (2012). While there may be little justification for why there is a difference in treatment between a direct forgiveness of indebtedness and forgiveness occurring as part of a property sale, that is the current status of the law. Parker ultimately is paying for this potentially nonsensical rule.[16]

Businesses often, even usually, are advised to operate through legal entities separate from their owners. This can be for both tax and non-tax reasons, such as protection from personal liabilities from business activities. Also, borrowers prefer nonrecourse loans which avoid subjecting their assets to liabilities beyond the direct collateral pledged. Here, however, Parker ended up receiving less favorable tax treatment because he operated through an S corporation with nonrecourse loans. Even though he was the 100% shareholder, paying tax on all of Exterra’s income, and agreed to subject his separate, personal assets to a default under the relevant loans through his personal guarantees, the Tax Court rightly looked to Exterra as a separate legal entity in its analysis.

Choices made when structuring businesses including the form of state law legal entity, tax elections, structure of debt, and other items, can affect both tax and non-tax outcomes. As with most choices, there are pros and cons to many of those decisions. It is unlikely when Exterra was formed, the Livermore property was purchased, and the relevant debts were incurred, that Parker anticipated selling the property for “nominal consideration” years later while Exterra was insolvent. However, that is what eventually happened. It also is unlikely that Exterra or Parker could have structured the transactions such that the debt forgiveness was not “as a result of” the property sale.[17]


Parker unfortunately suffered the cons associated with the choices made in his business structuring. If Exterra were a partnership or disregarded entity for income tax purposes rather than an S corporation, this outcome may have been avoided. If the debts were recourse to Exterra (which effectively was the case anyway since the debts were recourse to Parker, Exterra’s 100% shareholder), this outcome may have been avoided. This can be a lesson to business owners, who often are optimistic when starting new business endeavors, to understand both the good and bad that can go along with the choices they make and to regularly consult with their tax and business advisors as circumstances change.

[1] Parker v. Commissioner, TC Memo 2023-104.

[2] Some of the facts are simplified in this writing such as the ownership of the subject real property by disregarded subsidiaries of the S corporation and status of certain debts as senior or mezzanine.

[3] For a discussion of state law LLC’s taxed as S corporations, see Edmondson, Gray, “LLC v. S Corp.: Is That Really The Question?,” Jul. 16, 2021,

[4] IRC § 108(a)(1).

[5] IRC § 61(a).

[6] IRC § 61(a)(11),

[7] IRC § 108, which also requires that the taxpayer benefitting from this exclusion reduce its tax attributes (such as cost basis in assets) as an offset against the exclusion. This reduction was reported by Exterra when filing its amended income tax return.

[8] IRC § 1001(b).

[9] Treas. Reg. § 1.1001-2(a)(1).

[10] Simson v. Commissioner, 150 T.C. 201, 205 (2018).

[11] Treas. Reg. §1.1001-2(a)(4)(i).

[12] Treas. Reg. § 1.1001-2(a)(1) and Commissioner v. Tufts, 461 U.S. 300, 317 (1983).

[13] Treas. Reg. §1.1001-(a)(2) and (a)(4)(ii).

[14] See Estate of Delman v. Commissioner, 73 T.C. 15, 31-32 (1979).

[15] This treatment would be different if Exterra were a tax partnership, another form of passthrough entity, rather than an S corporation. This is because Treas. Reg. § 1.752-1(a) treats a partnership liability as recourse to the extent that any partner or related party bears the economic risk of loss associated with the liability. No such rule exists for S corporations.

[16] In this regard, see Justice O’Connor’s concurrence in Commissioner v. Tufts, 461 U.S. 300 (1983), where she addresses the illogic of this treatment.

[17] See, e.g., Sands v. Commissioner, TC Memo 1997-146, where the Tax Court expressed doubt that lenders would independently forgive debt when the borrower still holds the collateral.


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