Source: http://cclawyer.cccba.org/2011/06/the-dark-side-of-debt-forgiveness/
Timestamp: 2014-12-19 07:56:38
Document Index: 353822993

Matched Legal Cases: ['§ 61', '§ 108', '§ 108', '§ 108', '§ 108', '§ 108', '§ 108', '§ 108', '§ 108', '§108', '§ 108', '§ 108', '§ 1017', '§ 108', '§ 108', '§ 1017', '§ 522', '§ 1017']

The Dark Side of Debt Forgiveness : Contra Costa Lawyer Online
Elliott Abrams | Jun 01, 2011 | Comments 0
Generally, under Internal Revenue Code (IRC) § 61(a)(12) cancelation of debt (COD) is taxable as ordinary income. However, under certain circumstances such income can be excluded under IRC § 108 where, the COD occurs as a result of a discharge in a title 11 bankruptcy case (IRC § 108(a)(1)(A)), where the discharge occurs when the taxpayer is insolvent (IRC § 108(a)(1)(B)), where the indebtedness discharged is qualified farm indebtedness (IRC § 108(a)(1)(C)), where the indebtedness discharged is qualified real property business indebtedness (IRC § 108(a)(1)(D)), or where the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013 (IRC § 108(a)(1)(E), the “2007 Mortgage Relief Act”).
There is no free lunch when it comes to exclusion of the COD. The “price” for exclusion occurs under IRC § 108(b) which requires that the taxpayer’s tax attributes be reduced by the amount of the income excluded. In many cases, IRC § 108 only defers payment of the tax on the COD income. The method by which the tax attributes are reduced differs under each subsection of IRC §108(a)(1). Only the exclusion of COD income resulting from a bankruptcy discharge will be discussed.
In determining the amount of COD income, IRC § 108(e)(2) provides that “[n]o income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.” For example where there is a foreclosure the amount of debt forgiveness does not include accrued but unpaid interest since the taxpayer could have deducted the interest if paid. Likewise where a landlord forgives unpaid rent owed by a business debtor, this discharge would not be COD income since the taxpayer could have deducted the rent as a business expense if paid.
The reduction in basis under IRC § 108(b)(2)(E) in a Title 11 case is governed under the provisions of IRC § 1017(b)(2) which limits the reduction to the excess of the “(A) aggregate of the bases of the property held by the taxpayer immediately after the discharge, over (B) the aggregate of the liabilities of the taxpayer immediately after the discharge.” Treasury Regulation 1.1017-1(b)(3) provides that aggregate liabilities must be reduced by the amount of any cash on hand. Treasury regulation 1.1017-1(a) prescribes the order in which the bases in the taxpayer’s property is reduced. Property where the tax attributes are reduced in the above order, is not limited to depreciable property but consists of all the property of the taxpayer.
Alternatively, the taxpayer can elect under IRC § 108(b)(5) to first apply any portion of the required reduction to the taxpayer’s depreciable property before any other tax attributes are reduced. Under this election the reduction in basis is not limited to the excess of basis over liabilities but can reduce the basis to zero (IRC § 108(b)(5)(B)). Property under this election is limited to depreciable property of the taxpayer (IRC § 1017(b)(3)).
If the excluded COD income exceeds the sum of the taxpayer’s tax attributes, the excess is permanently excluded from the taxpayer’s gross income (Treasury Regulation 1.108-7(a)(2)).
Finally, and most importantly, in bankruptcy cases only, where COD income is excluded from gross income, there is no basis reduction to any property which is claimed as exempt under Bankruptcy Code § 522 (IRC § 1017(c)(1)).
If Dan does not elect to first apply the discharge of indebtedness income against his depreciable property, the $350,000 of discharge of indebtedness income will first reduce his remaining NOL of $25,000 to zero. There will be no reduction in basis for Dan’s home as it was claimed as an exempt asset in his bankruptcy schedules. There will be no reduction in basis for Dan’s rental property as its liabilities exceed its basis. There will be no reduction in basis of Dan’s other property (e.g. car, furniture, jewelry, etc.) as he has claimed those assets as exempt in schedule C. The discharge of indebtedness income will next reduce Dan’s passive loss carryforward to zero and the remaining $290,000 will forever escape taxation.
If Dan were to elect to first apply some or a portion of the discharge of indebtedness against his depreciable property, he could reduce his basis in the rental by the full $350,000 of discharge of indebtedness income from $400,000 to $50,000 (there is no limitation under this election other than Dan can only reduce the basis of depreciable property and not below zero). In this case he would retain both this NOL carryforward and the passive activity loss carryforward. The $25,000 NOL remaining after netting against Dan’s 2010 income would carryforward to future years, his passive loss carryforward would continue to be available, but he would face a much larger potential gain from a future sale of the rental with the first $350,000 taxable as ordinary income. Making this election would not seem to make sense unless Dan planned to hold the property for a very long time and calculated that the retention of the tax attributes outweighed the additional future tax, or Dan had a very short life expectancy and expected to die owning the property which would step up the basis to fair market value upon death.
Elliott Abrams is a Walnut Creek attorney specializing in tax, estate planning and bankruptcy matters. He is a sole practitioner and has been in practice in Contra Costa County for thirty years. www.eabramslaw.com
Tags: cancellation of debt • debt • insolvency • IRS • property • tax
June 2011 &nb