Under section 108(c) of the Internal Revenue Code, a taxpayer may make an election to exclude COD from gross income if the COD qualifies as qualified real property business indebtedness. Qualified real property business indebtedness is defined in §108(c) and generally means indebtedness that is secured by real property and incurred or assumed by a taxpayer in connection with a trade or business. A taxpayer who makes this election is required to reduce the basis of the depreciable real property at the beginning of the taxable year following the taxable year in which the discharge occurs. IRC §1017(2)(2). A taxpayer who disposes of the qualified real property in the year in which the COD occurs cannot elect to exclude COD income under IRC § 108(c).

Section 703(b) of the Internal Revenue Code requires a partnership to make all elections affecting the taxable income of the partnership except in three specifically enumerated cases. One of these cases is the election to exclude COD income that qualifies as qualified real property business indebtedness. Under §703(b), the election to exclude this income must be made at the partner's level rather than by the partnership at the partnership level. A partner choosing to make this election must first obtain the consent of the partnership and then make the election in the manner and time frames permitted in the Federal Income Tax Regulations, Reg § 1.1017-1(g). Once the election has been properly made, the partnership is required to reduce the electing partners basis of depreciable partnership property commencing in the tax year following the year the COD income is excluded. The partnership must then adjust the partner's distributive share of partnership income, deductions, gains, and losses to reflect these basis adjustments in subsequent years in the manner prescribed under section 743(b) of the Internal Revenue Code and in the Federal Income Tax Regulations, Reg §1.743-1.

In the case of partners in a real estate limited partnership who elect to exclude COD income arising from qualified real property business indebtedness, adjustments must be made by the partnership in subsequent tax years to report the additional income the partners must recognize as the result of the required basis adjustments, either through the reduced depreciation deductions or because of increased gains on the sale of the depreciable property. The additional income from these basis adjustments is reported by the partnership in subsequent tax years on the federal 1065 schedule K filed by the partnership and as a separately stated item on the K-1 forms provided to the partners. Since reporting the separately stated items from the COD in the year the COD occurs and in the year(s) the §743 income adjustments are required would result in double taxation on the MBT return, the partnership should report the COD in the year the §743 income adjustments are reported to the partners and not in the year the COD occurs. To the extent a §108(c) election has not been made by a partner(s), the COD attributable to that partner(s) is then reported on the MBT return in the same year the COD occurs.

Copies of all timely elections made by partners to exclude COD income should be attached to the partnership's MBT return in the year the COD occurs to allow the Department to determine the amount, if any, of COD that should be included in the partnership's MBT income tax base in that year.