Rabelais, famed author of the French Renaissance, wrote in his will “I owe much; I have nothing; the rest I leave to the poor.” No one doubts the author’s excellent estate planning, but those who “owe much” in today’s troubled economy -- and the real estate market in particular – are increasingly concerned about the tax consequences of debt forgiveness. The general rule is that gross income includes income from cancellation of debt (“COD”); in other words, the full amount of the forgiven or cancelled debt is taxable. Exceptions to the taxability of COD began to develop from various court rulings until Congress enacted IRC § 108 over fifty years ago to codify the exceptions. This article provides an overview of the more important debt forgiveness provisions typically encountered in the current economic environment.
The two most common exclusions under Section 108 are for bankruptcy and insolvency. COD income will be excluded if the taxpayer is a debtor in a federal bankruptcy case and the debt was discharged either by order of the bankruptcy court or pursuant to a court approved liquidation plan. Insolvency exists if a taxpayer’s liabilities exceed the fair market value (“FMV”) of his assets, measured immediately before the debt forgiveness. The “price” for using the bankruptcy or insolvency exception is a corresponding reduction to the taxpayer’s positive tax attributes, including NOLs, tax credits, capital and passive loss carry forwards, and basis in depreciable assets. The taxpayer has the option to reduce the basis of depreciable property before reducing the other tax attributes. If the COD exceeds all of the tax attributes required to be reduced, the excess is never taxed. Note that both the attribute and basis reductions occur on the first day of the year following the debt forgiveness, which can provide tax planning opportunities. For instance, the taxpayer might accelerate income into the year of the debt discharge in order to utilize NOLs before they are lost by the reduction rules.
A taxpayer who is neither bankrupt nor insolvent has other possibilities available to exclude COD income. For example, a taxpayer can elect to exclude the forgiveness of qualified real property indebtedness (“QPRI”) from income. QPRI is secured debt used to acquire or substantially improve real property used in a trade or business, including rental real estate. The maximum amount that can be excluded as QPRI is the excess of the outstanding mortgage (including accrued interest) over the FMV of the property. The amount excluded cannot exceed the adjusted bases of the taxpayer’s other depreciable property, which is reduced if the taxpayer elects to exclude the COD income. Depreciable property acquired in contemplation of a discharge of QPRI does not increase the limitation.
Another exclusion for solvent taxpayers is for purchase money debt. Under this provision, if a seller-financed mortgage is reduced, the basis of the property securing the mortgage is lowered instead of generating COD income. It is treated as if the purchase price of the property were adjusted downward. This basis reduction, like the others in section 108, defers the recognition of COD income rather than permanently eliminating it. Depreciation expense is reduced on the taxpayer’s other properties, and an eventual sale of the property will generate a larger gain due to the basis reduction. The amount of the gain equal to the excluded COD income is treated as depreciation recapture.
On December 20, 2007 “The Mortgage Forgiveness Debt Relief Act of 2007” was enacted allowing married taxpayers to exclude up to $2 million of COD income arising from the reduction of the mortgage on, or foreclosure of their principal residence. This provision originally applied for years 2007, 2008 and 2009, but it was extended through the end of 2012 by enactment of “The Emergency Economic Stabilization Act of 2008” on October 3, 2008. This provision can be combined with the other exclusion provisions discussed above if part of the forgiven debt fails to qualify under this provision.
The tax consequences from the transfer of real estate in satisfaction of a debt are significantly different depending upon whether the debt is recourse or nonrecourse. A transfer of property in satisfaction of a recourse mortgage is bifurcated into two types of income. The excess, if any, of the debt over the FMV of the underlying property is COD income, and the excess of the FMV of the property over its basis is treated like gain on a sale the property. For property secured by a nonrecourse mortgage, the transfer is treated as a sale of the property for the amount of the mortgage, with the resulting gain or loss taxed as a normal property sale. No COD income is realized from the transfer of property in satisfaction of a nonrecourse liability, and as a result, the section 108 exclusions do not apply. Note that a reduction in or forgiveness of a recourse or nonrecourse debt, rather then a transfer of the underlying property in satisfaction of the debt, will generate COD income.
An important distinction exists in the treatment of COD income between an S corporation and partnership or LLC. For S corporations, the bankruptcy and insolvency tests, as well as the reduction of tax attributes, are all made at the corporate level. For partnerships and LLCs this is done at the partner or member level, This means that COD income from a partnership or LLC could have a different impact on the partners or members depending upon their individual financial conditions and personal tax elections. And a partnership must consent to a partner’s election to reduce his or her share of the partnership’s depreciable property. Another important distinction for S corporations is that COD income does not increase a shareholder’s basis in his stock.
Debt forgiveness is a complex area of the tax code. A thorough understanding of the facts is critical to understanding the tax consequences and potential planning opportunities. Planning before the debt is forgiven or reduced can often improve the tax consequences from an otherwise difficult financial situation. For more information, please contact you local CBIZ MHM office, and we will be happy to assist you.
Copyright © 2009. CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that—unless specifically indicated otherwise—any tax advice in this communication (and any attachments) is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.