Taxpayer Requirements for Debt Cancellation or Forgiveness
Taxpayer Requirements for Debt Cancellation or Forgiveness
Because of the economic downturn, many individuals are, not surprisingly, finding it harder and harder to pay off their debts. For example, credit card companies recently reported that the default rate for August 2009 was the highest since the start of the recession.
One result is that tax return preparers may see a significant number of Form 1099-Cs when they sit down with their clients to prepare 2009 tax returns.
Form 1099-C is the information return that commercial lenders must send out when they cancel or forgive a borrower's debt in whole or in part. If the canceled debt exceeds $600 the lender must file a Form 1099-C with the IRS (and send a copy to the borrower), reporting the amount canceled in Box 2 of the form.
As a general rule, canceled debt (cancellation-of-debt or COD income) is taxable to the borrower. Cancellation of a personal debt is reported on Line 21 of the borrower's Form 1040. However, just because a client receives a Form 1099-C does not mean that you should automatically report the Box 2 amount on Line 21. You may discover that, despite what the form states, there may be no COD income or the amount reported on Form 1099-C may be incorrect. Or you may find that, even when there is COD income, the client may be able to avoid tax by qualifying for one of the exceptions to the general rule.
In such cases, remember that there will be a presumption that the Form 1099-C is correct. So when the Form 1040 reporting is at odds with the Form 1099-C, you and your client must be able to provide proof justifying the discrepancy. So as a practitioner, you must be sure to look beyond the Form 1099-C to look at other considerations.
Two new Tax Court decisions illustrate the questions that can arise when clients receive a Form 1099-C.
Has There Been a Cancellation of Debt?
If a debt for which you are personally liable (recourse debt) is canceled or forgiven, other than as a gift or bequest, the amount canceled is ordinary income. COD income from a personal debt is reported on Line 21 of Form 1040.
If you are not personally liable for the debt (nonrecourse), the cancellation of debt does not result in COD income unless one of the following conditions exists:
- The lender offers a discount for the early payment of the debt [Rev. Rul. 82-202].
- The lender agrees to a loan modification that results in the reduction of the principal balance of the debt [Rev. Rul. 91-31]..
If you do not make payments on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale from which the client may realize gain or loss. If the outstanding loan balance was more than the fair market value of the property and the lender cancels all or part of the remaining loan balance, the client may also realize COD income. The amount of the COD income is the difference between (1) the outstanding balance before the foreclosure or repossession and (2) the fair market value of the property, reduced by (3) any amount of debt the client is still liable for after the foreclosure or repossession.
A lender who forecloses or repossesses your property should send you a Form 1099-A, Acquisition or Abandonment of Secured Property, showing information to figure gain or loss. However, if the lender also cancels part of your debt and must file Form 1099-C, the lender can include the information about the foreclosure or repossession on Form 1099-C instead of on Form 1099-A.
NEW CASE. Steed Martin purchased an automobile, financing the purchase through Heritage Community Credit Union. Martin stopped making payments on his loan with Heritage during 2001, and Heritage canceled the $6,704 outstanding principal of Martin's loan. The automobile was repossessed in 2002. During 2005 Heritage issued a Form 1099-C to Martin reflecting the cancellation of his debt of $6,704. That information was also communicated to the Internal Revenue Service. Martin did not include the $6,704 in income for 2005, but the IRS made an adjustment for increased income based on the 1099-C.
Martin challenged the accuracy of the 1099-C. He contended that the value of the automobile at the time of the repossession was approximately $6,704, equivalent to the outstanding loan principal with Heritage.
The Tax Court agreed with Martin. The court accepted Martin's valuation since "an owner is presumed to know or have a good sense of the value of his property." Martin purchased the automobile during 1999 for $12,360. The court believed that a value of $6,704 when the automobile was repossessed was reasonable (one-half of its original value). The IRS presented no evidence to the contrary. Thus, the court concluded that Martin had no COD income [Martin, T.C. Summ. Op. 2009-121].
Is the COD Income Exempt from Tax?
There are several exclusions from the general rule that COD income is taxable [IRC Sec. 108].
Bankruptcy. Debt canceled in a Title 11 bankruptcy case is not included in your income. A Title 11 bankruptcy case is a case under Title 11 of the United States Code, but only if you are under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
Insolvency. COD income is not taxable to the extent that you were insolvent immediately before the cancellation. An individual is insolvent immediately before the cancellation to the extent that the total of all of the client's liabilities exceeded the fair market value of all of his or her assets immediately before the cancellation.
For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of creditors under the law, such as your interest in a pension plan).
NEW CASE. Lawrence Hill obtained a credit card from Provident Bank in 1991. Hill did not make payments and Provident obtained a judgment against him in state court. Hill filed for bankruptcy shortly thereafter. Lawrence's bankruptcy case was dismissed in 1996 because he did not make payments required under an order of the bankruptcy court. Provident sent annual letters informing Lawrence of his account balance. In 2004 Provident forgave Lawrence's debt. Provident issued a Form 1099-C which reported $4,156 in COD income. Lawrence did not include the $4,156 in his gross income for 2004. The IRS issued a deficiency notice.
When the case came before the Tax Court, the court upheld the deficiency notice. Because Lawrence did not meet the obligations of the bankruptcy plan, his debts were not discharged in bankruptcy, and, thus, did not qualify for the bankruptcy exception for COD income.
Lawrence did not show that he qualified for the insolvency exception for COD income. He did not produce any evidence showing that his liabilities exceeded the fair market value of his assets at the time the debt was canceled [Lawrence, T.C. Memo. 2009-101].
The implication for tax practitioners is clear.
PRACTICE TIP. To claim the insolvency exception successfully, your client must, in effect, draw up a financial statement showing that his or her liabilities exceed assets. IRS Publication 4681, Canceled Debts. Foreclosures, Repossessions, and Abandonments, provides a worksheet that can be used for this purposes.
Home Mortgage. A client can exclude COD income if it stems from canceled "qualified principal residence indebtedness." Qualified principal residence indebtedness is any debt incurred in acquiring, constructing, or substantially improving a principal residence (second homes are ineligible) and which is secured by the principal residence. Qualified principal residence indebtedness also includes any debt secured by a principal residence resulting from the refinancing of debt incurred to acquire, construct, or substantially improve a principal residence but only to the extent the amount does not exceed the amount of the refinanced debt. The maximum amount that can be treated as qualified principal residence indebtedness is $2 million ($1 million if married filing separately).
Claiming an Exclusion. If you are eligible to exclude COD income, you must reduce certain "tax attributes" by the amount excluded. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), is used to calculate this reduction and it must be attached to your return. The reduction of tax attributes is made after figuring your income tax liability for the year of the exclusion.
If you exclude canceled qualified principal residence indebtedness from income and you continue to own the home after the cancellation, the basis of the home must be reduced by the amount of the canceled debt.
For other exclusions, the tax attributes are reduced in the following order (but not below zero) until the reduction equals the excluded amount.
- Net Operating Loss (NOL). Reduce the current year's NOL first followed by NOL carryovers from prior years, starting with the earliest year.
- General Business Credit Carryover. Reduce the credit carryover to or from the current year by 33 1/3 cents for each dollar of excluded canceled debt.
- Minimum Tax Credit. Reduce the minimum tax credit available at the beginning of the following year by 33 1/3 cents for each dollar of excluded canceled debt.
- Capital Loss. First reduce any net capital loss for the current year and then any capital loss carryover from prior years.
- Basis. Reduce the basis of property held at the beginning of the current year in the following order (and within each category, in proportion to adjusted basis).
- Real property (except inventory) used in a business or held for investment that secured the canceled debt.
- Personal property (except inventory and accounts and notes receivable) used in a business or held for investment that secured the canceled debt.
- Other property (except inventory, accounts and notes receivable, and real property held primarily for sale to customers) used in a business or held for investment.
- Inventory, accounts and notes receivable, and real property held primarily for sale to customers.
- Personal use property (property not used in a trade or business nor held for investment).
