Canceled Debt May Leave Taxes Due

Fred Witt

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.