April 2012
Canceled Debt May Leave Taxes Due
Financially troubled taxpayers may be left with
taxes due after a debt reduction; after 30 years, a reexamination of Section 108
may be appropriate.
Taxpayers may be surprised to learn that, if they borrow
$1,000 and, due to financial hardship, repay only $600, the $400 difference is
taxable as ordinary cancellation of debt (COD) income.[1] Many discover
this issue when they receive a Form 1099-C, "Cancellation of Debt," issued by a
bank reporting the amount of COD income to the IRS.[2] The common refrain
is, "If I've lost money due to the financial downturn and my creditors have
settled for less than the full amount owed, how can this ‘lost money’ also be
taxable?"
There are rules under Section 108 intended to provide tax
relief for COD income, but these rules have not been comprehensively reviewed by
Congress in more than 30 years. Unfortunately, because of interim changes in the
tax law and changes in how transactions are structured, there are several COD
events that trigger immediate taxation rather than providing the preferred
deferral of taxes that financially troubled taxpayers so clearly need.
Interestingly, if Section 108 had remained unaltered from its original 1980
version, financially troubled taxpayers would be able to obtain much of the
relief they seek. Given the ripple effect of the prolonged economic downturn,
amending Section 108 and making permanent the principal residence exception (set
to expire in 2012) would provide taxpayers with needed certainty.
Current Law
Gross income is broadly defined to include income from the
discharge of indebtedness.[3] A discharge of indebtedness occurs when a debt is
forgiven or canceled, or when a creditor accepts payment of less than the unpaid
balance in complete satisfaction of the debt. The amount of gross income generally equals the excess of the
adjusted issue price of the obligation being canceled and the amount of consideration paid.[4]
Recognizing that most discharges occur when debtors are facing financial difficulties and are
least able to pay tax, Congress enacted Section 108 in the Bankruptcy Tax Act of 1980.[5] To preserve a financially troubled debtor's fresh start after a
debt discharge, Section 108 provides that discharge income is excluded from gross income if it is
realized by taxpayers (i) who are involved in a Title 11 case or are insolvent, or (ii) regarding particular types
of qualifying indebtedness.[6] Although the income is excluded, the taxpayer's tax attributes —
largely loss carryovers and the bases of property — are reduced by the excluded amount.[7] Any
excluded income in excess of tax attributes is permanently eliminated from the
taxpayer's gross income.[8] Section 108 also provides other stand-alone rules governing discharge income, including exceptions
from recognition when payment of the debt would have given rise to a deduction[9] and when the debt
arose out of the purchase of the property.[10]
History of Section 108
When Section 108 was enacted in 1980, it represented the codification of numerous statutory
and judicial rules developed over 50 years. It was comprehensive and achieved an
optimal balance between the debtor's interest in achieving a financial fresh
start and the government’s interest in the deferral and eventual collection of tax, through
the reduction of the debtor's tax attributes.[11] Thus, to the extent there was an eventual economic gain, the
tax would ultimately be collected in subsequent tax years when the debtor had the financial ability
today.[12] It also codified many specific rules, including those for lost
deductions, purchase money debt reductions, and the equity-for-debt exception to recognition.
After 1980, subsequent legislative changes to Section 108 that were intended to narrow the application of this optimal regime instead resulted
in serious adverse consequences for financially troubled debtors. These changes created
complexity and impediments to the ability of debtors and creditors to work out troubled debt
economically without the imposition of immediate, additional tax liabilities. Thus, the limitations on the
deductibility of interest[13] and repeal of the qualified business indebtedness exception in 1986,[14] the repeal of
the equity-for-debt exception in 1993,[15] and the judicial narrowing of the definition of the insolvency exception[16] have created a perfect storm of problems
and unintended consequences for debtors and creditors seeking to work out troubled debt.
Given the severe downturn in the housing market, a special rule for the treatment of qualified principal residence debt was enacted in 2007 to
address the housing crisis,[17] in part due to an inherent mismatch: Although
any debt reduction was taxable income, any loss on disposition was not
deductible. An example featuring a financially troubled homeowner illustrates
the negative tax impact and unpredictability of the tax result. Assume a
taxpayer purchased a house in 2006 for $100,000 with no money down. The
principal residence appreciates, and to pay off other non-residence debts, the
taxpayer takes out a home equity loan for $20,000. In 2009 she falls behind on
her payments and the lender forecloses in satisfaction of the $100,000 loan and
forgives the $20,000 second loan. There’s no gain on the foreclosure — but even
if there were, gains up to $250,000 (up to $500,000 for married taxpayers filing
jointly) on the sale of a principal residence are excluded.[18]
Unfortunately, that’s not the end of the tax analysis. Forgiveness of the $20,000 loan is taxed
as ordinary COD income. Section 108 provides for relief under these facts, but only to the extent
the taxpayer is insolvent (measured immediately before the forgiveness).[19] Most taxpayers would
assume they are insolvent if their liabilities exceed their assets. However, under current judicial
authority, retirement assets such as IRAs and retirement plans that may be exempt from the reach of creditors
are counted as assets for purposes of the tax insolvency exception.[20] As a
result, counting her retirement assets, the taxpayer in the example will not be
insolvent and the $20,000 will be additional income taxed at ordinary rates.[21]
Might the taxpayer benefit from the qualified principal residence exclusion[22] enacted in the Mortgage Forgiveness Debt Relief Act of 2007 and effective for tax years 2007 through 2013?
Unfortunately, this exclusion will not prevent her from recognizing COD income in connection with the discharge
of her second loan (the home equity loan). The exclusion applies only to a mortgage "incurred in acquiring, constructing, or substantially improving
any qualified residence of the taxpayer," as well as certain refinancing of this mortgage debt.[23]
Because the taxpayer used the second loan to pay off non-residence debts (as opposed to improving the residence), the debt amount is not qualified
principal residence indebtedness and is not eligible for exclusion under
Section 108(a)(1)(E).
Former Rules Provided Greater Financial Relief
Ironically, if the objective were to provide troubled debtors with a "fresh start" deferral
of income and a chance for economic rehabilitation, the provisions of Section
108 as originally enacted in 1980 served the purpose. It was an optimal statutory regime that addressed most debt workout situations and
provided an appropriate balance and result from the perspectives of both the
taxpayer and the government.
In contrast to the current regime, taxpayers would regain stronger financial footing if they were
given the flexibility to defer current recognition of COD income while paying a price for this deferral —
the reduction of tax attributes. A return to prior law would include the reenactment of the qualified business debt exception (allowing all business
taxpayers to elect to reduce the basis of depreciable property rather than currently recognizing discharge
income from business indebtedness[24] and the equity-for-debt exception for corporations and
partnerships. The following changes could supplement the relief provided by
Section 108 and modernize the resolution of current challenges:
-
make the qualified principal residence indebtedness exception permanent;
-
treat all non-deducted interest, including personal interest, as if deductible for purposes
of Section 108(e)(2);
-
clarify that retirement and other assets exempt from creditors under the taxpayer's
applicable state law are not counted as assets in the insolvency calculation;
-
clarify that the term "discharge" is to be interpreted
broadly to include forgiveness of indebtedness whether or not such
indebtedness is discharged for bankruptcy purposes;
-
clarify that partners may claim their share of partnership debt in their personal
insolvency calculation (and include nonrecourse debt if it is the subject partnership nonrecourse
debt being reduced), as provided under Rev. Rul.92-53[25]; and
-
clarify that Section 108(e)(6) applies to partnerships, so that the forgiveness of a debt owed
to a partner/ creditor becomes a nontaxable contribution to capital to the extent of the
partner's adjusted basis in the debt.
Why Does This Matter?
The right of debtors to restructure their financial affairs
and obtain a fresh-start discharge of prior obligations is so fundamental that
it is found in the bankruptcy clause of the Constitution.[26] Allowing
a debtor to obtain a release or discharge of a liability because of financial hardship, but leaving her
with a federal tax liability, seems incongruent with the underlying fresh-start policy.
More to the point, if a debtor settles a $1,000 debt for $600, the $400 difference is treated as
taxable COD income subject to exclusion and deferral under Section 108. If none
of the Section 108 exclusions apply, the debtor must report the $400 as
additional ordinary income. Assuming a 20 percent federal tax rate, the debtor will owe an additional $80 of
tax. Lacking the ability to pay, the debtor will be subject to the IRS collection system when the tax
becomes delinquent.[27] Generally, the IRS will file a notice of federal tax lien (NFTL) to protect the
government's interests.[28] For 2011, the IRS reported there were one million liens filed and almost four million levy notices served on third parties.[29] The effect of
an NFTL on a taxpayer's credit is not academic.[30] According to National Taxpayer Advocate Nina
Olson:
An NFTL severely damages the financial welfare of the affected taxpayer and may
reduce the federal revenue and tax compliance for years to come. Specifically,
it significantly harms the taxpayer's credit and thus negatively affects his or
her ability to obtain financing, find or retain a job, secure affordable housing
or insurance and ultimately pay the outstanding tax debt.[31]
Conclusion
Financially troubled debtors who work out their obligations with lenders in hopes of securing a
fresh start potentially face the burden of additional taxes. In 1980, Congress codified numerous judicial
and statutory rules in Section 108. The statute achieved an appropriate balance between the debtor's interest in receiving a fresh start and the
government's interest in the deferral and eventual collection of tax through the reduction of tax attributes. After 30 years, however, these rules have evolved in a
way that may thwart some taxpayers’ ability to start anew financially. Ironically, numerous
problems and pitfalls under current law could be avoided if Section 108 had remained unchanged. A return
to the original intent and text would be a good place to start the reexamination.
1 Section 61(a)(12)
2 Section 6050P
3 Section 61(a)(12)
4 Section 108(e)(10)
5 P.L. 96-589, section 2(a) (1980)
6 Section 108(a)(1)
7 Section 108(b)
8 Reg. Section 1.108-7(a)(2)
9 Section 108(e)(2)
10 Section 108(e)(5)
11 S. Rep. No. 96-1035, at 8, 10(1980)
12 Id.
13 Tax Reform Act of 1986, P.L. 99-514, section 511(a) and (b). See Brooks v. Commissioner, T.C. Memo. 2012-25, Doc 2012-1642, 2012 TNT 18-6 (the taxpayer failed to establish that canceled interest would have been deductible, and the court held that canceled interest COD income not excluded under section 108(e)(2))
14 TRA 1986, P.L. 99-514, section 822(b)(3)
15 Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, section 13226(a) 16 See Carlson v. Commissioner, 116 T.C. 87 (2001), Doc 2001-11702, 2001 TNT 81-23
17 Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142, section 2.
18 Section 121
19 Section 108(a)(1)(B) and (d)(3)
20 See Carlson, 116 T.C. 87
21 See Stevens v. Commissioner, T.C. Summ. Op. 2008-61, Doc 2008-12257, 2008 TNT 108-9 (short sale on two-story residence); Gale v. Commissioner, T.C. Summ. Op. 2006-152, Doc 2006-19316, 2006 TNT 179-21
22 Section 108(a)(1)(E)
23 Section 108(h)(2)
24 This would obviate the need to extend the
section 108(i) deferral for discharge income from an applicable debt instrument
enacted in the American Recovery and Reinvestment Act of 2009, RL. 111-5,
section 1231
25 1992-2C.B.48
26 U.S. Const., Art. I, Section 8, Cl. 4
27 See Vinatieri v. Commissioner, 133 T.C. 392 (2009) Doc
2009-28069, 2009 TNT Z44-Z0 (The IRS sought to enforce a levy against a taxpayer
who had $800 monthly income, $800 of expenses, and a car valued at $300. The Tax
Court ordered the levy released because of economic hardship)
28 Sections 6321 and 6323
29 IRS Data Book 2011 at 41 (Mar.2012), Doc 2012-6059, 2012 TNT 57-20
30 National Taxpayer Advocate, “2011 Annual Report to Congress,” at 12-14 (Dec,
31, 2011), Doc 2012-588, 2012 TNT 8-16 (the IRS needs to do more to alleviate
the harm its lien filing practices can create for many taxpayers)
31 "Complexity and the Tax Gap: Making Tax Compliance Easier and Collecting
What's Due," Hearing Before the U.S. Senate Finance Committee (June 28, 2011), Doc 2011-14097, 2011 TNT 125-48 (statement by Olson, Section
VI.B)
Article © Fred Witt 2012. All Rights Reserved.
Disclaimer: This alert is
provided for general information purposes and is not intended to constitute
legal advice. Please consult with your own legal or tax advisor before making
any decisions concerning your financial or business matters. |