INCOME FROM CANCELLATION OF INDEBTEDNESS
by Robert Swaim, Accountant and Enrolled Agent | 2009
During a March 18 IRS phone forum on cancellation of indebtedness income, Anne Freeman, IRS chief of review, gave an overview of Code Sec. 108′s cancellation of indebtedness income resulting from foreclosures and short sales where the lender has to “eat” a portion of the unpaid mortgage, with a focus on applicable exceptions to the general rule that mortgage forgiveness by the lender results in taxable income to the borrower.
The IRS is currently working on an update to Publication 4681, which explains the federal tax treatment of canceled debts, foreclosures, repossessions and abandonments, said Freeman. You can print a copy of this booklet from the IRS web site, www.irs.gov.
Cancellation of Debt Under Code Sec. 108
Code Sec. 108 generally excludes from gross income discharges of indebtedness (also known as “COD” income) IF:
(1) the discharge occurs in a title 11 bankruptcy case,
(2) the discharge occurs when the taxpayer is insolvent,
(3) the indebtedness is “qualified farm indebtedness,” or
(4) the indebtedness is “qualified real property business indebtedness.”
In addition, as a temporary relief provision during the current housing crisis, discharged qualified principal residence indebtedness (QPRI) is excluded for discharges on or after January 1, 2007, and before January 1, 2013. Exclusions from income are allowed under Code Sec. 108 in an order of priority.
Definition of “Qualified Real Property Business Indebtedness”:
Taxpayers, other than C corporations, are permitted to exclude income attributable to cancellation of qualified real property business indebtedness. This exclusion does not apply to qualified farm debt, which is covered by a separate exclusion discussed above. In order to be considered “qualified” the real property business indebtedness must have been incurred or assumed before January 1, 1993, in connection with realty used in a trade or business that secures the debt. For indebtedness incurred on or after that date to qualify for the exclusion, it must be either qualified acquisition indebtedness, which is indebtedness incurred or assumed to “acquire, construct, reconstruct, or substantially improve… .” the property securing the debt, or indebtedness obtained to refinance, but not add to, pre-1993 qualified real property business indebtedness.
Additionally, taxpayers must make an election to exclude forgiveness of indebtedness income attributable to qualified real property business indebtedness. The election is made by checking the box on line 1d of Form 982 and filing it along with the taxpayer’s federal tax return. Taxpayers who file a timely return who are eligible to make the election but fail to do so may still make the election by filing an amended return within six months of the original due date, excluding extensions, with the notation “Filed pursuant to Section 301.9100-2″ written on the amended return. Once a proper election is made, it may not be revoked unless permission to do so is obtained from the IRS.
EXAMPLE: In 1989, Wayne Smith purchased rental property, which he used in his business, for $15 million. He financed the acquisition with a $12 million nonrecourse mortgage. The current fair market value of the property has dropped to $8 million, a figure well below both its original cost and the amount of the outstanding nonrecourse debt. The holder of the nonrecourse debt has agreed to release the mortgage in exchange for a cash payment of $7 million. The adjusted basis of the property is $9.5 million, with $2 million allocable to the basis of the land and the remaining $7.5 million allocable to the depreciable building.
The existing $12 million nonrecourse debt would be satisfied with only $7 million in cash, leading to a $5 million discount that would ordinarily be a taxable discharge of indebtedness income. The qualified real property business indebtedness requirements are met. If Smith makes a Code Sec. 108(c) election, current recognition of part of this income could be avoided. The amount of discharge of indebtedness income that Smith can elect to exclude is limited to $4 million (the outstanding principal amount of debt determined immediately before the discharge ($12 million) minus the fair market value of the real property securing the debt ($8 million)) ( Code Sec. 108(c)(2)(A)). The second, overall limit on the amount of the exclusion is the total amount of the adjusted bases of all the taxpayer’s depreciable real property held immediately before the discharge. Here, Smith owns the one item of depreciable real property, and its $7.5 million adjusted basis exceeds the $4 million of discharge of indebtedness income. Discharge of indebtedness income will be recognized in the amount of $1 million.
The basis of Smith’s depreciable real property is reduced by the amount of excluded discharge of indebtedness income –resulting in a basis of $3.5 million ($7.5 million – $4 million). The basis is reduced at the beginning of the tax year following the year in which the discharge occurred.
Taxpayers are allowed the qualified real property business indebtedness exclusion only to the extent that the outstanding principal amount of real property business debt, reduced by the amount of any reduction in that debt that qualifies for the insolvency exclusion, exceeds the fair market value of the property securing the debt. If there is additional business debt secured by the real property, the fair market value of the property must first be reduced by the amount of that additional indebtedness in making the calculation. Additionally, there is an overall limitation which prohibits taxpayers from excluding qualified real property business indebtedness in excess of the adjusted bases of the qualified depreciable realty held immediately before the cancellation, (exclusive of any such property acquired in contemplation of the debt cancellation).
Generally, taxpayers must reduce certain tax attributes to the extent that income from the discharge of indebtedness is excluded from gross income under Code Sec. 108. Tax attributes reduced under this provision include the adjusted basis of properties, net operating losses, passive activity losses and credit carryovers. In many cases Code Sec. 108 operates to defer, rather than eliminate, income from discharge of indebtedness, Freeman explained.
Bankruptcy and Insolvency Exceptions
Freeman discussed three major exclusions from gross income for: (1) bankruptcy, (2) insolvency (your net worth is negative), and (3) a qualified principal residence. She clarified that the bankruptcy exclusion for Title 11 bankruptcies “takes precedence over any other exclusion under Code Sec. 108.” Freeman further noted that “because no dollar limit is associated with it [the bankruptcy exclusion], you wouldn’t need another exclusion to apply.”
Insolvency is the second exclusion in order of priority. However, unlike under the bankruptcy exclusion, dollar limits apply, Freeman clarified. The “concept is much easier than the calculation,” according to Freeman. She revealed that the IRS is in the process of creating an insolvency worksheet to “help with the calculation.” Very simply: If the debt forgiven is $75,000 and your net worth is NEGATIVE $37,000, then $38,000 [$75,000 - $37,000] of the debt forgiveness is taxable and $37,000 [$75,000 - $38,000] is not taxable.
The extent to which the taxpayer is insolvent for purposes of the exclusion is calculated by subtracting the fair market value (FMV) of total assets immediately before the discharge from the total amount of liabilities immediately before the discharge. Freeman noted that “accrued liabilities, like accrued real estate taxes and assets generally beyond the reach of creditors” must also be included in the calculation.
Robert Swaim holds a Masters in Accounting and is an Enrolled Agent in Charleston, SC. He works with real estate investors for tax returns, audit defense and other IRS problems. He can be contacted at 843-722-5264 or Robert@CarolinaTax.net