Income From Discharge Of Indebtedness

Based on the discussion in <a href="http://pro.moss.nuco.com/taxfacts2018/tfinv/p19-dischargdebt/Pages/8090-00-TF2.aspx">Q 8104</a> and <a href="http://pro.moss.nuco.com/taxfacts2018/tfinv/p19-dischargdebt/Pages/8091-00-TF2.aspx">Q 8105</a>, a taxpayer who receives a Form 1099-C has the following two concerns: (1) has the debt been formally discharged by the creditor, and, if so, was it discharged in that year; and (2) is the discharge of debt taxable?<br /> <br /> As to the first concern, based on the majority view discussed in <a href="http://pro.moss.nuco.com/taxfacts2018/tfinv/p19-dischargdebt/Pages/8091-00-TF2.aspx">Q 8105</a>, the taxpayer should contact the creditor to request formal confirmation of its discharge of the debt as well as the year of discharge. By securing a formal confirmation, the creditor would be barred from pursuing legal action against the taxpayer. If the creditor fails to provide the taxpayer with formal confirmation, the taxpayer should attempt to ascertain the validity of the identifiable event the creditor relied upon in issuing the Form 1099-C.<br /> <p style="padding-left: 30px"><em>Example</em>: In 2019, Asher received a Form 1099-C from a credit card company. In Box 6, Code G (decision or policy to discontinue collection) was entered. Although Asher requested a formal confirmation of the discharge in 2019, the credit card company failed to respond. Upon further review of his documentation, Asher ascertained the credit card debt was incurred in 2008 and the applicable statute of limitations for collection expired in 2011. Therefore, Code C (statute of limitations or expiration of deficiency period) was the proper identifiable event that should have been reported in 2011. Based on that information, Asher can challenge the inclusion of the discharged debt as income in 2019 as well as defend any subsequent collection action initiated by the credit card company.</p><br /> As to the second concern, the receipt of a Form 1099-C reporting a substantial amount of discharged debt can be a daunting experience because of a large potential tax liability. As discussed in <a href="http://pro.moss.nuco.com/taxfacts2018/tfinv/p19-dischargdebt/Pages/8087-00-TF2.aspx">Q 8101</a>, however, a Form 1099-C is simply a reporting requirement of the creditor and does not establish whether the amount reported is taxable to the debtor. For that reason, the taxpayer should consider the various exclusions (discussed in <a href="http://pro.moss.nuco.com/taxfacts2018/tfinv/P19_incdisceindebt/Pages/8105-00-TF2.aspx">Q 8119</a> to <a href="http://pro.moss.nuco.com/taxfacts2018/tfinv/P19_incdisceindebt/Pages/8110-00-TF2.aspx">Q 8124</a>) that may apply to render all or part of the discharged debt nontaxable.<br /> <p style="padding-left: 30px"><em>Example</em>: In 2020, Asher received a Form 1099-C from a credit card company reporting a substantial amount of discharged debt. However, the debt reported on the Form 1099-C was discharged in bankruptcy. Because debt discharged in bankruptcy is excluded from gross income, Asher would not be taxed on such income. Attaching Form 982 to his 2020 Form 1040, Asher should check line 1a, and, thus, exclude it from gross income.</p>

The following chart illustrates a comparison of the five discharge of debt exclusions:<br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td valign="top" width="170">Exclusion Type</td><br /> <td valign="top" width="208">Amount Excluded</td><br /> <td valign="top" width="161">Reduction of Tax Attributes</td><br /> </tr><br /> <tr><br /> <td valign="top" width="170">Bankruptcy</td><br /> <td valign="top" width="208">Unlimited</td><br /> <td valign="top" width="161">Yes</td><br /> </tr><br /> <tr><br /> <td valign="top" width="170">Insolvency</td><br /> <td valign="top" width="208">To the extent of insolvency</td><br /> <td valign="top" width="161">Yes</td><br /> </tr><br /> <tr><br /> <td valign="top" width="170">Qualified Farm Indebtedness</td><br /> <td valign="top" width="208">To the extent of “adjusted tax<br /> attributes” plus basis in qualified property</td><br /> <td valign="top" width="161">Yes</td><br /> </tr><br /> <tr><br /> <td valign="top" width="170">Qualified Real Property<br /> Business Indebtedness<br /> (elective)</td><br /> <td valign="top" width="208">Subject to two limitations:<br /> <br /> 1. To the extent amount forgiven exceeds FMV of secured property.<br /> <br /> 2. To the extent of basis of<br /> depreciable real property.</td><br /> <td valign="top" width="161">Reduction of basis of<br /> secured property.</td><br /> </tr><br /> <tr><br /> <td valign="top" width="170">Qualified Principal Residence Indebtedness</td><br /> <td valign="top" width="208">Up to $2,000,000</td><br /> <td valign="top" width="161">None, unless taxpayer retains the residence. In that case, the basis of the residence is reduced by the amount of discharged debt.</td><br /> </tr><br /> </tbody><br /> </table>

<div class="Section1"><br /> <br /> The tax concept of gross income is broad enough to include any economic benefit enjoyed by a taxpayer.<a href="#_ftn1" name="_ftnref1">¹</a> When a taxpayer borrows funds, he or she enjoys an economic benefit (i.e., to pay for a vacation, purchase property, etc.). As long as the taxpayer has a corresponding obligation to repay the loan, however, the economic benefit of the borrowing is not taxable. In other words, the taxpayer’s obligation to repay the loan from his or her own funds offsets the economic benefit of the borrowing.<br /> <blockquote><em>Example:</em> Assume Asher borrows $10,000 to take a two-week European vacation. The loan bearing market interest is payable in full, two years later. Two years later, Asher repays the loan. Although the loan enabled Asher to pay for a vacation (clearly an economic benefit), his obligation to repay the loan with his own funds negates any inclusion in gross income.<br /> <br /> On the other hand, if prior to repayment, the creditor forgives the debt, the rationale for not taxing the economic benefit of the borrowing is no longer applicable. This is because at that point, it is clear that the taxpayer is no longer required to repay the debt, so the amount of the discharge is treated like any other economic benefit enjoyed by the taxpayer and is included in gross income.<br /> <br /> <em>Example:</em> Assume Asher borrows $10,000 to take a two-week European vacation. The loan bearing market interest is payable in full, two years later. Two years later, when the loan is due, Asher defaults. Rather than pursuing a legal collection action, the lender forgives the entire debt. As a result of the discharge, Asher is no longer obligated to repay the loan. Thus, the economic benefit of the use of $10,000 that Asher will never repay is includible in gross income.</blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 61(a).<br /> <br /> </div>

<div class="Section1">Clearly, the discharge of the obligation to repay debt is an economic benefit received by the debtor as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>, above, and the unconditional discharge of debt for no consideration is includible in gross income under IRC Section 61(a)(12). On the other hand, if the debtor provides consideration to the creditor, the creditor is deemed to have paid the amount of the debt to the debtor as compensation, which, the debtor in turn used to repay the debt. Under those circumstances, the transaction is treated as an exchange of money for services or property rather than discharge of debt income includible under IRC Section 61(a)(12).<br /> <blockquote><em>Example</em>: Asher borrows $10,000 from his employer to take a two- week European vacation. When the loan becomes due, Asher&rsquo;s employer forgives the debt. Because of their employee/employer relationship, the amount of the discharged debt is treated as compensation (not income from discharge of indebtedness). In other words, it is as if Asher&rsquo;s employer paid him $10,000 as compensation for services, which Asher in turn used to repay the debt. Therefore, the forgiven debt is treated as wage income includible under IRC Section 61(a)(1) rather than IRC Section 61(a)(12).<br /> <br /> <em>Example</em>: Asher borrows $10,000 from Ashley to take a two-week European vacation. When the loan becomes due, in lieu of repayment, Ashley accepts a painting from Asher worth $10,000 that he purchased three years ago for $2,000. In this case, it is as if Asher sold the painting to Ashley for $10,000, which Asher in turn used to repay the debt. Similar to any taxable sale or exchange of property, Asher must include $8,000 of capital gain income ($10,000 minus $2,000 (basis in painting)) under IRC Section 61(a)(3).</blockquote><br /> </div><br />

<div class="Section1">The Form 1099-C regulations that govern this issue may cause confusion. In the case of multiple debtors (who are subject to joint and several liability) with respect to the discharge of $10,000 or more of indebtedness, the regulations require the creditor to issue a Form 1099-C to each debtor. With respect to spouses (who are co-obligors), only one Form 1099-C is required to be sent. Moreover, on each Form 1099-C (if more than one is sent to multiple debtors), the full amount of the discharged debt is reported. So if multiple debtors each receive a Form 1099-C, there may be confusion as to how much of the discharged debt each debtor must report.<br /> <blockquote><em>Example</em>: Asher, Ashley and Joel are jointly and severally liable with respect to a $120,000 bank loan. Two years later, the bank forgives the loan and issues each co-obligor a Form 1099-C reporting the discharge of the entire $120,000 loan. If each co-obligor was required to report $120,000 as discharge of debt income, it would be triple counted.</blockquote><br /> Although there are no regulations on point and no court has addressed this issue, in a chief counsel advice memorandum, the IRS stated that the full amount of discharge of debt should be allocated among the co-obligors (including co-obligor spouses) based on all the facts and circumstances. Thus, in the above example, if Asher, Ashley and Joel were equal partners, the $120,000 of discharged debt should be allocated among them equally.<br /> <br /> </div>

<div class="Section1">A “debt” arises by virtue of the receipt of money or acquisition of property by an individual who has a corresponding obligation to repay the creditor/lender in money or money’s worth. The terms “recourse” or “nonrecourse” describe the creditor/lender’s ability to pursue legal collection action against a defaulting debtor.</div><br /> <div class="Section1"><br /> <br /> In the case of a default on a recourse debt (whether the debt is secured or unsecured), the creditor has the legal right to sue the debtor personally to satisfy any deficiency. So, in the case of a secured recourse loan, if the fair market value of property is not sufficient to pay the outstanding balance, the debtor remains personally liable to satisfy the deficiency. Conversely, with respect to a default of a nonrecourse debt (which is always secured by property), the creditor’s remedy is limited to the property securing the debt. Stated differently, beyond surrendering the secured property to the creditor, the debtor has no personal obligation to repay the loan even if the secured property is not sufficient to pay off the entire debt.<br /> <blockquote><em>Example</em>: In 2023, Asher purchases raw land for $100,000 financed entirely with the proceeds of a 10-year recourse loan secured by the land. Until the maturity date of the loan in 2033, only interest payments were required. In 2026, Asher defaults on the loan (fails to make the required interest payments) and the lender forecloses. After crediting the fair market value of the land (which had declined to $70,000) against the loan, there remains a balance of $30,000. Because the debt is recourse, however, the lender may sue Asher personally to secure payment of the deficiency from his other assets.<br /> <br /> In the alternative, if Asher’s loan was nonrecourse, the only collection option available to the lender is foreclosure or accepting a deed in lieu of foreclosure. Beyond that remedy, the lender may not pursue a legal action against Asher in order to collect the $30,000 deficiency. In other words, the transfer of the secured property to the lender is deemed to satisfy the loan regardless of the outstanding balance.</blockquote><br /> </div>

<div class="Section1">Yes. Although it may seem incomprehensible as to how a transaction that generates a tax loss can also trigger discharge of debt income, it is possible.<br /> <blockquote><em>Example:</em> Assume Asher purchased a commercial building totally funded with the proceeds of a $100,000 recourse loan secured by the building. Several years later when the principal amount of loan was still $100,000, Asher defaulted on the loan and the lender foreclosed on the property. At that time, the fair market value of the building was $80,000 and the adjusted basis of the building was $90,000 (original basis reduced by $10,000 of depreciation deductions). After crediting the fair market value of the property against the outstanding balance of the loan, the lender chooses to forgive the $20,000 shortfall for no consideration. Because the fair market value of the property was only $80,000, it is as if Asher sold the building to the lender for $80,000 which he, in turn, used as a partial repayment of the loan. Since the basis of the building was $90,000, Asher has a $10,000 taxable loss pursuant to IRC Section 165 ($90,000 basis minus $80,000 basis). The $20,000 remaining balance written off by the creditor would be considered discharge of debt income under IRC Section 61(a)(12).</blockquote><br /> </div>

<div class="Section1">The foreclosure of secured property with respect to recourse or nonrecourse debt has income tax consequences. In either case, the lender acquires the property from the debtor. Consequently, the lender is required to issue a Form 1099-A (a copy to the IRS and a copy to the debtor). The Form 1099-A provides relevant information the debtor needs to determine the income tax consequences of the foreclosure.<div class="Section1"><br /> <br /> For example, entered in Box 1 is the date of the foreclosure (treated as the date of sale). In Box 2, the outstanding balance of the debt immediately prior to the foreclosure is entered. In Box 4 and Box 6, the fair market value and the description of the property are entered, respectively. In Box 5, the lender indicates whether the lender was personally liable, i.e., whether the loan was recourse. If the box is checked, it is recourse, if not, it is nonrecourse.<br /> <br /> Importantly, in the case of recourse debt, the issuance of Form 1099-A does not mean the lender has forgiven any deficiency (the difference between the outstanding balance of the debt and the fair market value of the property). If subsequent to the foreclosure, the lender chooses to forgive the deficiency, a Form 1099-C should be issued (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8115">8115</a>).<br /> <br /> </div></div><br />

Pursuant to the Mortgage Debt Relief Act of 2007, the discharge of <span class="italic"><em>qualified principal residence indebtedness</em> </span>of up to $2 million dollars is excluded from gross income. Although the relief was due to sunset in 2010, it was subsequently made permanent by the Protecting Americans Against Tax Hikes Act of 2015 (PATH).<br /> <br /> “Qualified principal residence indebtedness” is a secured loan used to acquire, construct or substantially improve a principal residence. For this reason, it does not include a home equity loan that is not used to substantially improve the principal residence. A refinanced loan is also considered qualified principal residence indebtedness to the extent of the outstanding balance of the loan it is to replace. Any additional borrowing from the refinanced loan is not considered qualified principal residence indebtedness unless the proceeds are used to substantially improve the principal residence.<br /> <blockquote><span class="italic"><em>Example</em></span>: A lender approved a short sale of Asher’s principal residence for $700,000. Asher’s home was secured by recourse debt of $1,000,000 of which only $800,000 was qualified principal residence indebtedness and the balance was a home equity loan used to pay off personal debt. After applying the $700,000 proceeds from the short sale to the outstanding loan, the lender forgave the remaining $300,000. Under this scenario, only $100,000 of the discharged debt (the qualified principal residence indebtedness) is excluded from gross income. As to the remaining $200,000, unless some other discharge of debt exclusion applies, it would be included in gross income.</blockquote><br /> Finally, if both the qualified principal residence indebtedness exclusion and insolvency exclusion apply, the taxpayer can elect to use the insolvency exclusion. Also, a taxpayer who takes advantage of this exclusion is not required to reduce any tax attributes unless he or she retains the principal residence. If so, the basis of the principal residence must be reduced by the amount of the excluded discharge of debt income.

<div class="Section1"><br /> <br /> As discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8113">8113</a>, the discharge of debt is an economic benefit conveyed upon the debtor. In essence, a discharged debt is equivalent to receiving money (i.e., the amount borrowed that will never be repaid). The context in which the debt is discharged will determine how it is to be reported. Assuming the forgiven debt is a &ldquo;pure&rdquo; discharge, however, it is deemed to be &ldquo;income from discharge of indebtedness&rdquo; specifically includible in gross income pursuant to IRC Section 61(a)(12). For this purpose, pure discharge of debt requires an unconditional forgiveness for no consideration.<br /> <blockquote><em>Example</em>:&nbsp;Asher borrows $10,000 to take a two-week European vacation. Two years later, when the loan becomes due, Asher defaults. In lieu of pursuing a legal collection action against Asher, the lender forgives the entire loan. Because the forgiveness of the loan was unconditional for no consideration from Asher, the $10,000 forgiveness is considered to be &ldquo;income from discharge of indebtedness&rdquo; includible in gross income under IRC Section 61(a)(12).</blockquote><br /> </div><br />