Continuing Professional Education

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1 Continuing Professional Education Course Number CPE20908 Revision Date: 11/15/2008 Debt Relief Income & Insolvent Taxpayer Exclusion Learning Objectives After completing this course, the student will be able to compute debt relief income and exclusions for: Abandonment of Secured Property, Foreclosures, Repossessions, Short Sales, Cancellation of Debt, Insolvent Taxpayer Exclusion and Debt Forgiveness under the Home Mortgage Debt Relief Act of 2007 Continuing Education Credit: 3 Hr CTEC #1044-CE-2209 (3 Hr Fed Credit) Study Level: Intermediate to Advanced Prerequisites: None Copyright 2008 This material is designed to provide the experienced tax professional with theory and practical knowledge for a variety of problems encountered in preparing individual income tax returns. This material is not intended for client use and as such does not comply with the Circular 230 requirements for Covered Opinions. Special emphasis is given to the latest tax law changes, court cases, IRS rulings and regulations. The text incorporates examples and problems to illustrate points that have a practical application of law. This material is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service and assumes no liability whatsoever in conjunction with its use. Tax laws are continually changing and are subject to differing interpretations. You are cautioned to do additional research before acting on information contained in this course.

2 Correspondence Course CPE Information CPE INFORMATION Certified Public Accountants: ClientWhys Inc. is registered with the National Association of State Boards of Accountancy as a sponsor of continuing professional education on the National Registry of CPE sponsors. State Boards of accountancy have final authority on the acceptance of individual courses. Complaints regarding registered sponsors may be addressed to NASBA, 150 Fourth Ave. North, Nashville, TN IRS Enrolled Agents: ClietWhys, Inc. also qualifies for CPE credit for Enrolled Agents under agreement with the IRS Office of Professional Responsibility. Certified Financial Planners: CPE credit for this course has been granted by the CFP Board of Standards. California Registered Tax Preparers: ClientWhys, Inc. has been approved by the California Tax Education Council to offer continuing education that meets the annual requirements imposed by the State of California. A listing of additional requirements to renew tax preparer registration may be obtained by contacting CTEC at PO Box 2890, Sacramento, CA , by phone at (877) , or on the Internet at PASSING GRADE: Passing grade is 70%. If you fail the first time, you will be allowed a second chance to pass the exam. Although citations are included throughout the course materials, the answers to the test questions can all be determined without the use of supplemental materials. CPE CERTIFICATE: For courses taken on-line the CPE certificate is generated at the time the final examination is successfully completed and can be printed from the internet site. For other methods of study, a CPE certificate will be mailed to you upon the successful completion of the course. ERRATA: Any text or exam question changes will be posted on the website. Comments may be faxed to or ed to technical@clientwhys.com. COMPLAINT RESOLUTION: For more information regarding our administrative policies such as complaint or refund please contact our offices at We maintain an elaborate website as a service to our students.

3 Debt Relief & Insolvent Taxpayer Exclusion CONTENTS Overview 2 Related IRS Publications and Forms 3 Step #1 Determine if Taxpayer is Insolvent 3 Calculating Insolvency 3 Don t Practice Law 3 Step #2 Determine the Amount of Debt Relief Income 3 Forms 1099-A and 1099-C 4 Recourse Versus Nonrecourse Debt 4 Computing Sale Price 5 Home Office Loss Issues 5 Review Questions 6 Debt Relief Worksheet 8 Automobile Repossession Example 8 Home Repossession Example 8 Special Issues 9 Gifts 9 Deductible Debt 9 Interest Included in Cancelled Debt 9 Price Reduced After purchase 10 Pass-through Entities 10 Abandonment by the Borrower 10 Bankruptcy 10 Step #3 Exclude Debt Relief Income to Extent of Insolvency or. 10 Taxpayer Solvent 10 Student Loans 11 Qualified Farm Debt 11 Qualified Real Property Debt 11 Exclusion Limit 11 Basis Reductions 11 Taxpayer is Insolvent 11 Things to Consider 12 Review Questions 13 Step #4 Home Mortgage Debt Forgiveness Rule 16 Step #5 Reduction of Tax Attributes 16 Order of Reduction 17 Special Elections 17 Step #6 Complete IRS Form Review Questions 21 Cancellation of Debt Worksheet 24 Insolvency Worksheet 25 1

4 Debt Relief & Insolvent Taxpayer Exclusion DEBT RELIEF, INSOLVENT TAXPAYER EXCLUSION, AND FORECLOSURE ISSUES Code Section 108 Debt Relief Income - Whenever a debt of a taxpayer is forgiven, whether it is credit card debt, home mortgage debt or other debt, the forgiven debt (debt relief) is generally taxable income to the taxpayer unless (1) the debt was discharged in a bankruptcy proceeding or (2) the taxpayer qualifies for exclusion of debt relief income. Insolvency Exclusion - Debt relief can be excluded from income to the extent a taxpayer is insolvent. o Insolvency Simply stated insolvency is the amount by which a taxpayer s debts exceed the FMV of their adjusted assets, determined immediately before the debt is discharged. Adjusted Assets The FMV of a taxpayer s assets not counting the assets excluded under bankruptcy law. Other Exclusions Available for the discharge (forgiveness) of the following types of debt: o Qualified farm indebtedness* o Qualified student loan indebtedness o Qualified real property business indebtedness* o Certain principal residence debt *Insolvency exclusion takes precedence when the taxpayer has this type of debt Home Acquisition Debt Forgiveness for 2007 through 2012 taxpayers can exclude up to $2 Million ($1 Million for MS) of qualified principal residence acquisition debt Overview o Principal Residence Has the same meaning as for the Sec 121 home sale gain exclusion. o Acquisition debt Is debt incurred to purchase, construct or substantially improve the principal residence and is secured by that home. Tax Attributes Reduced If debt relief is not taxed because an exclusion applies, tax attributes (for example, carryover losses or credits) must be reduced, up to the amount of debt relief. Concept is Not Complicated The concept of debt relief is not complicated but computing the appropriate exclusion is time consuming with lots of details. When a principal residence is involved, it also creates certain issues related to sale of the home since home foreclosures almost always generate debt relief income. Once you see the big picture the details fall into place. This course emphasizes the issues related to the insolvency and home acquisition debt exclusions. It will take you through the many details involved in computing the insolvent taxpayer exclusion, and in the case of a foreclosure on a principal residence, determine (A) the amount of debt relief and (B) if there is home sale gain as a result of the foreclosure. Handling debt relief issues, and the sequence of this course, are broken down into the six steps below: Step #1 - Determine if the taxpayer is insolvent Step #2 - Determine the amount of debt relief income Step #3 - Exclude debt relief income to the extent of insolvency (or one of the other exclusions, if applicable), or Step #4 Use home mortgage debt forgiveness rule to exclude debt relief income Step #5 Reduce tax attributes (if any) by the excluded amount Step #6 Complete IRS Form 982 2

5 Forms Pubs Debt Relief & Insolvent Taxpayer Exclusion Related IRS Publications and Forms o Form 1099-A Acquisition or Abandonment of Secured Property o Form 1099-C Cancellation of Debt o Instructions Form 1099-A and 1099-C o Pub Bankruptcy Tax Guide o Pub 4681 Canceled Debts, Foreclosures, Repossessions and Abandonment NEW! o Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness Step #1 Determine if the Taxpayer is Insolvent (not applicable if in bankruptcy) A taxpayer is insolvent to the extent their liabilities exceed the fair market value of their assets determined on the basis of the taxpayer s liabilities immediately before the discharge (Code Sec. 108(d)(3)) Assets ($) Liabilities ($) Insolvency Thus, to the extent of the insolvency, the taxpayer can exclude debt relief income. Of course, if the assets exceed the liabilities the taxpayer is not insolvent and therefore not able to exclude the debt relief income under the insolvent taxpayer exclusion provision. CALCULATING INSOLVENCY: There is NO FORM provided by the IRS for this calculation. One possibility would be to use Form 433-A (for individuals) or 433-B (for businesses) that IRS Collections uses as a financial statement. There is also a simple worksheet in the end of this material. REMINDER! DON T PRACTICE LAW! - This is dangerous ground! It takes a command of both tax law and bankruptcy law. To handle a complex client, you should work WITH an attorney wellgrounded in bankruptcy law for the state in question! Step #2 - Determine the amount of debt relief income 1099-C: A financial institution, credit union, federal government agency or others in the business of lending money must issue a 1099-C if the debt relief is $600 or more. This form will generally provide the information needed to determine the amount of debt relief. The 1099-C can be issued for a variety of circumstances related to debt forgiveness including credit card debt, vehicle repossessions, home foreclosures, etc. Foreclosure - is a legal procedure whereby the lender sells or repossesses the property when the borrower has stopped making payments on the loan. Foreclosure rules and procedures vary from state to state. 3

6 Debt Relief & Insolvent Taxpayer Exclusion Forms 1099-A and 1099-C: A lender who acquires an interest in a property in a foreclosure or repossession should issue Form 1099-A showing the information needed to figure the taxpayer s gain or loss. However, if the lender also cancels part of the debt and must file Form 1099-C, the lender can include the information about the foreclosure or repossession on that form instead of on Form 1099-A. The 1099-A includes the amount of the debt relieved and the FMV of the property which should be the auction price. Box 2 Shows the amount of the debt cancelled (will also include the amount in Box 3) Box 3 Shows the amount of the interest that may or may not be included in debt relief income (See special issues below) Box 7 FMV of abandoned or foreclosed property or the taxpayer will receive a separate 1099-A RECOURSE/NONRECOURSE: There is no debt relief where the debt on the property is nonrecourse. Thus: Non-recourse debt (1) : o Debt Relief = 0 o Sales Price = Total amount of relieved debt. o Gain or loss determined in the normal manner. Recourse Loans (2) : o Debt Relief = Amount of loan forgiven o Sales Prices = FMV of the property at time of disposition o Gain or loss determined in the normal manner. (1) A nonrecourse debt is one where the borrower is not personally liable but the loan is secured by a pledge of collateral (usually property). If the borrower defaults (stops making payments) on a nonrecourse loan, the lender can seize the collateral but cannot go after other assets of the borrower. (2) A recourse debt is a debt where the borrower is personally liable for any short-fall remaining after the lender forecloses against the property, i.e., the borrower is expected to use other assets plus the mortgaged property to cover the loan balance. 4

7 Debt Relief & Insolvent Taxpayer Exclusion COMPUTING SALE PRICE SALE PRICE OF PROPERTY Type of Foreclosure Voluntary Reconveyance Loan (or abandonment) (also short sale ) Recourse Lesser: FMV or Loan Bal. Lesser: FMV or Loan Bal. Nonrecourse Greater of Loan Bal. Or FMV Loan Balance IMPORTANT ISSUE If a property subject to the debt relief is the taxpayer s primary home then the Sec 121 (home sale gain) exclusion applies, or if needed, the unforeseen circumstances reduced-gain exclusion applies. If there is a loss the loss would not be deductible since it is personal use property. If the home was partially business mixed use property at the time of sale, no loss is allowed. Mixed use means it is used both for personal and business use. (Reg (a) LOSSES NOT ALLOWED. A loss sustained on the sale of residential property purchased or constructed by the taxpayer for use as his personal residence and so used by him up to the time of the sale in not deductible under section 165(a). Thus this regulation presumably applies in a mixed use situation.) If the business use was in a separate structure then there would be two separate sales with no loss allowed on the personal use portion. The gain or loss would be recomputed for the business use portion taking into account the depreciation taken. If the result is a loss, the loss is allowed on the business part. If the result is a gain, the gain is taxable and does not qualify for the Sec 121 exclusion. 5

8 Debt Relief & Insolvent Taxpayer Exclusion Review Questions Read and answer the following review questions. The correct answers are found below the review questions with an explanation. 1. Which of the following does the text suggest is the first issue to be addressed when dealing with a debt relief situation? a. Complete Form 982. b. Determine if the taxpayer is insolvent. c. Prepare Form 1099-C. d. Reduce tax attributes. e. Figure the amount of debt relief income. 2. Under the debt relief rules of IRC Section 108, a taxpayer is considered insolvent: a. To the extent their liabilities exceed their assets. b. If their current tax return results in a net operating loss. c. When their assets exceed their liabilities. d. To the extent the loan on their personal residence exceeds their basis in the property. e. None of the above. 3. A non-bankrupt taxpayer must use IRS Form 433-A when calculating insolvency for purposes of the insolvency exclusion of debt relief income. a. True b. False 4. Form 1099-C, Cancellation of Debt, is required to be issued in which of the following situations? a. A credit card company forgives the taxpayer s $500 credit card balance. b. A lender repossesses an auto and forgives the difference between the recourse loan balance of $8,000 and the vehicle s FMV of $5,500. c. Only if Form 1099-A is also issued. d. Both a and c. e. Both b and c. 5. If the indebtedness on a property is a non-recourse loan, the amount of debt relief income is the amount of the loan that is forgiven. a. True. b. False. 6

9 Debt Relief & Insolvent Taxpayer Exclusion Review Questions Answers and Discussion Q1 The answer is (b), determine if the taxpayer is insolvent (see page 1). Figuring the amount of debt relief income is the second step. Later in the process is reducing the tax attributes, and then delineating them on Form 982. The Form 1099-C is not prepared by the taxpayer but by the lender who canceled the debt. Therefore, all of the choices except (b) are incorrect statements. Q2 insolvency is the amount by which a taxpayer s debts exceed the FMV of their assets, determined immediately before the debt is discharged. Income tax deductions exceeding the current year s income is not a factor in determining insolvency. Also, just because a loan on a property is greater than the taxpayer s basis in the property does not indicate insolvency; the difference between fair market value and indebtedness (liabilities) of all of the taxpayer s assets determines whether there is insolvency. Basis is not a factor. Therefore, only (a) is the correct answer. See page 2. Q3 The answer is b, false, because the IRS does not have a specific form that must be used when calculating insolvency. Form 433-A may be used; the worksheet at the end of this text offers a simpler calculation format. See page 3. Q4 A financial institution, credit union, federal government agency or others in the business of lending money must issue a 1099-C if the debt relief is $600 or more. No 1099-C is required in choice (a) because the debt canceled was less than $600. A lender who acquires an interest in a property in a foreclosure or repossession should issue Form 1099-A; the issuance of a 1099-C is independent of the 1099-A, so choice (c) is not correct. The recourse debt forgiven by the lender in (b) is $1,500, so it exceeds the floor for issuing a 1099-C and is a correct statement. Since choices (d) and (e) both include choice (c), which is not correct, they are both incorrect. Thus (b) is the answer. See page 4. Q5 - Recourse loans allow the lender to hold a borrower personally responsible for the amount of the loan. If the reacquired property isn t valuable enough to pay off the note, the lender may make claims on other assets of the debtor in order to get full payment. If the lender forgives the debt, there is debt relief and ordinary income. But with a non-recourse loan, if the property is taken back by the lender, the debt is satisfied by the property, regardless of its current value, and the lender has no claim on other assets. Thus there can be no debt relief and no debt relief income. The correct answer is False, choice (b). Refer to the text on page 4. 7

10 Debt Relief & Insolvent Taxpayer Exclusion IRS WORKSHEET IRS Publication 4681 includes a worksheet to determine the amount of debt relief. That worksheet has been modified to be more step by step than the IRS version and is included at the back of this material. The following examples follow the IRS worksheet. Example 1 Car Repossession Sonja purchased a car for $15,000 which was not used for business. She paid $2,000 down and took out a $13,000 recourse loan from a credit company. Sonja stopped making her loan payments and the credit company repossessed the car. The balance on the loan at the time of repossession was $10,000 and the FMV of the car was $9,000. The credit company decided they would not be able to collect the $1,000 balance on the loan because Sonja had insufficient assets and forgave it. PART I 1a Enter the amount of outstanding debt immediately before the transfer of property.. $10,000 1b Enter any amount of line 1a for which the taxpayer remains personally liable immediately after the transfer of property.. 0 1c Subtract 1b from 1a $10, Enter the fair market value of the transferred property. 9, Ordinary income from the cancellation of debt (Subtract line 2 from line 1c. If less than zero, enter zero)... $1,000 PART II 4. If Part 1 was completed enter the smaller of line 1c or line 2. If Part 1 was not completed, enter the amount of outstanding debt immediately before the transfer of property.. $9, Enter any proceeds the taxpayer received from the foreclosure sale Add line 4 and line 5... $9, Enter the adjusted basis of the transferred property... $15, Gain or loss from foreclosure or repossession. Subtract line 7 from line 6... <$6,000> Note: Since the car was personal use property the loss is not allowed. Had it been partially business use property, the business portion of the gain or loss after taking into account the depreciation recapture would be reportable on Form Example 2 Home Repossession - Joan paid $200,000 for her home. She paid $15,000 down and took a recourse loan of $185,000 from a bank. Joan was unable to continue making payments and the bank foreclosed. When the bank foreclosed on the loan, the balance due was $180,000, the FMV of the house was $170,000, and Joan s adjusted basis was $175,000 due to a casualty loss she had previously deducted. At the time of the foreclosure, the bank forgave $2,000 of the $10,000 debt in excess of the FMV ($180,000 minus $170,000). Joan remained personally liable for the $8,000 balance. In this case, Joan has ordinary income from the cancellation of debt in the amount of $2,000. 8

11 Debt Relief & Insolvent Taxpayer Exclusion PART I 1a Enter the amount of outstanding debt immediately before the transfer of property.. $180,000 1b Enter any amount of line 1a for which the taxpayer remains personally liable immediately after the transfer of property.. $8,000 1c Subtract 1b from 1a $172, Enter the fair market value of the transferred property. $170, Ordinary income from the cancellation of debt (Subtract line 2 from line 1c. If less than zero, enter zero).. $2,000 PART II 4. If Part 1 was completed enter the smaller of line 1c or line 2. If Part 1 was not completed, enter the amount of outstanding debt immediately before the transfer of property.. $170, Enter any proceeds taxpayer received from the foreclosure sale Add line 4 and line 5... $170, Enter the adjusted basis of the transferred property... $175, Gain or loss from foreclosure or repossession. Subtract line 7 from line 6... <$5,000> Note: Assuming the home is personal use property the loss is not allowed. But see important issue above. CAUTION Just because ordinary income is calculated on the worksheet doesn t mean that it will be taxable, as the balance of this chapter explains. SPECIAL ISSUES: As with all things in taxes there are special issues to deal with. Gifts - There is no income from the cancellation of debt if the cancellation of the debt is intended as a gift. The gift is subject to the usual gift tax rules, so if the debt that is forgiven exceeds the annual gift exclusion, the lender may be required to file a gift tax return. Deductible Debt Cash basis taxpayers do not realize income from the cancellation of debt if the payment of the debt would have been a deductible expense. This exception applies before the price reduction exception (see below). Example Suppose you are the accountant for a small cash basis business. The business falls on hard times and cannot meet all of its liabilities. You decide to forgive a portion of the amount the business owes you. The forgiven amount becomes debt relief income to the business but is excluded from that company s income because it would have been deductible if paid. Interest included in canceled debt Sometimes interest is forgiven and included in the amount of canceled debt. Following the model of the deductible debt exclusion above, whether the interest portion of the canceled debt must be included in income depends on whether the interest would be deductible if paid. If the interest would not be deductible, such as on a personal loan, and none of the other exclusions apply, the interest included in the canceled debt would be taxable. Form 1099-C box 2 includes both forgiven interest and principal amount and box 3 indicates the amount of interest forgiven. 9

12 Debt Relief & Insolvent Taxpayer Exclusion In both of the following examples, no other exclusion of debt relief applies. Example 1 - A cash basis taxpayer had a non-business consumer loan debt forgiven, and the amount in box 2 of the 1099-C was $900 and the amount in box 3 (interest) was $300. The entire forgiven amount (box 2) would be debt relief income. Example 2 Another cash basis taxpayer had a business loan forgiven. The 1099-C she received also showed $900 (total forgiven) in box 2 and $300 (interest) in box 3. In this case only $600 ($900 - $300) would be treated as debt relief income because the interest would have been deductible if it were paid. Price Reduced After Purchase - If the debt owed the seller for the purchase of property is reduced by the seller at a time when the taxpayer is not insolvent and the reduction does not occur in a title 11 bankruptcy case, the reduction does not result in cancellation of debt income. However, the basis in the property must be reduced by the amount of the reduction of debt to the seller. Pass-through entities. If a partnership s liability is discharged, the partnership allocates the income from discharge of debt to the partners as a separately stated item. The debt relief is thus reported on Form 1040 by the partners. Any available exclusions are also applied at the partner level. Abandonment by the Borrower - Abandonment means that the borrower voluntarily conveys the property to the lender without a formal foreclosure. Deed in lieu of foreclosure is a common term for this. Loss from the abandonment of business or investment property is deductible as an ordinary loss, even if the property is a capital asset. The loss is the property s adjusted basis when abandoned (sales price is zero). If the abandoned property is personal use property such as a home or personal use vehicle then no loss is allowed. What if the lender does not know the borrower has abandoned the property? If it is a nonrecourse loan it makes no difference because there is no debt relief. However, if the loan was recourse and the lender subsequently forgives all or part of the debt then the debt relief income could occur in a subsequent year. Bankruptcy - Any debt which is forgiven under a Title 11 bankruptcy is excludable from income. Title 11 of the Federal Code contains all chapters of the bankruptcy codes, including Chapters 7, 11, and 13. The taxpayer who uses this exclusion must reduce tax attributes to the extent of the exclusion. In the case of bankruptcy, taxpayer is usually the bankruptcy estate. A debtor is rarely affected by debt relief in a bankruptcy proceeding. Step #3 - Exclude debt relief income to the extent of insolvency, or In step #1 we determined whether the taxpayer was insolvent and if so, to what extent. In step #2 we determined the amount and character of the debt relief. Now we need to determine the course of action for the next step, based on whether the taxpayer is solvent or insolvent.: TAXPAYER SOLVENT: Then it is clear that the debt relief income is taxable unless the debt relief qualifies for exclusion under the home mortgage, student loan, qualified farm, or real property business debt forgiveness rules. When there is taxable debt relief income report it as ordinary income on line 21 of the Consider if one or more of the following exclusions applies: 10

13 Debt Relief & Insolvent Taxpayer Exclusion Student Loans Generally there is no debt relief income as the result of a student loan debt or refinanced student loan being cancelled where the debtor agreed to work for a certain period of time in certain professions for any of a broad class of employers, and the student completed that obligation. Generally to qualify under this provision the loan and refinanced loan, if any, must have been made by a governmental agency, a tax-exempt public benefit corporation or an educational institution. Qualified Farm Debt - Farm debt involves special requirements for both the debtor and the lender. The debt must arise from running a farm business--more than 50 percent of the taxpayer s gross receipts for the 3 prior years must be from farming. The lender must be in the trade or business of lending and unrelated to the borrower. The lender can t be the same person that sold the property in question to the farmer. Certain tax attributes of the taxpayer must be reduced to the extent of the excluded debt relief income. Qualified Real Property Business Debt - Taxpayers (other than corporations) may exclude debt forgiveness from Qualified Real Property Business Indebtedness. Generally, this refers to debt incurred or assumed in connection with real property used in a trade or business and secured by the property. For this purpose, rentals are trade or business property. Any debt existing on 01/01/93 and secured by the property qualifies. For debts incurred after 01/01/93, the provision applies only to acquisition debt, although the debt may be refinanced to an amount no greater than the outstanding balance of acquisition debt at the date of refinance. O o Exclusion Limit - The Qualified Real Property Business Indebtedness excluded amount is limited by two factors: FMV limitation (Equity limitation) - The amount excluded cannot be more than the excess of the outstanding principal balance over the difference between FMV and the balance of any other outstanding debt on the property. In other words, relieved debt can be excluded up to the point at which further forgiveness would produce equity. Basis Limitation - The amount excluded cannot exceed the taxpayer s aggregate adjusted basis in depreciable real property immediately before the discharge (after basis reductions for the other three exclusions). Basis reduction - After exclusion, the basis of depreciable real property must be reduced by the amount of debt forgiven. If the taxpayer disposes of the property in conjunction with the cancellation of debt (foreclosures, for example), the basis reduction is made just BEFORE the exclusion. If the taxpayer does not have sufficient basis in the property to accommodate the reduction, the basis of other depreciable real property is reduced, generally in the first tax year AFTER the cancellation. TAXPAYER IS INSOLVENT: If the debt is not home mortgage debt then the next step is to exclude the debt to the extent of insolvency. If the debt is home mortgage debt then you have two options o Exclude to the extent of insolvency, or o Exclude using the home mortgage debt exclusion rule. 11

14 Debt Relief & Insolvent Taxpayer Exclusion Things to Consider The home mortgage debt forgiveness only applies to Acquisition Indebtedness while the insolvency rule applies to all debt. The home mortgage forgiveness rule allows up to $2 mil of debt relief while the insolvency exclusion only allows exclusion to the extent of insolvency. Some states do not conform to the home mortgage forgiveness rule and only allow the insolvent taxpayer exclusion, or other states, such as California, have a different limitation on the amount that can be forgiven under the home mortgage forgiveness rule and/or apply the rule to different years than under the federal rules. 12

15 Debt Relief & Insolvent Taxpayer Exclusion Review Questions Read and answer the following review questions. The correct answers are found below the review questions with an explanation. 6. George and Ellen purchased their home several years ago for $125,000 ($25,000 down, $100,000 mortgage). Two years ago they refinanced their mortgage; the new loan was a recourse loan of $90,000. The balance of the loan was $85,000 this year when they defaulted on the loan and the lender foreclosed. At about the same time a neighboring property sold for $80,000. Which statement is correct? a. George and Ellen have a nondeductible capital loss of $40,000. b. George and Ellen have a deductible capital loss of $45,000. c. There will be no debt forgiveness income because the loan was a recourse loan. d. Unless the lender forgives the balance of the loan, George and Ellen will not have any ordinary income due to debt cancellation. e. Both b and d. 7. With respect to debt relief, which statement is not correct? a. There is no debt relief income when the terms of an installment sale are renegotiated by the buyer and seller and the result is a reduction in the buyer s debt to the seller. b. A lender may have to file a gift tax return if the debt relief is intended as a gift. c. A partnership that had a discharged liability allocates it as a separately stated item to each partner. d. Interest included in the canceled debt is included in debt relief income if it would have been deductible had it been paid. e. All of the above. 8. Code Section 108 provides for an exclusion of debt relief income to a solvent taxpayer in the following situations, except when: a. Equity debt on real property acquired in 2000 and used in a trade or business is forgiven. b. Debt arose from operation of a farming business. c. Debt was incurred to purchase residential real estate used as rental property. d. Debt is forgiven in a Title 11 bankruptcy. e. All of the above. 9. For the farm debt exclusion to apply to debt forgiveness, which of the following is a correct statement? a. More than 75% of the taxpayer s gross income must be from farming. b. The taxpayer must have been in the farming business no more than 2 years. c. The lender may not be related to the borrower. d. The borrower must have purchased the property from the lender. e. None of the above. 13

16 Debt Relief & Insolvent Taxpayer Exclusion Review Questions Answers and Discussion Q6 Using the worksheet in the text, we determine that the couple had a loss on the sale of $45,000, as follows: Line 1a = 85,000 Line 1b = 5,000 Line 1c = 80,000 Line 2 = 80,000 Line 3 = 0 Line 4 = 80,000 Line 5 = 0 Line 6 = 80,000 Line 7 = 125,000 Line 8 = <45,000> However, a loss from the sale of personal use property is not a deductible loss. Therefore, neither answer (a) nor (b) is correct. Since the loan is recourse, any forgiven debt gives rise to debt relief. Therefore, answer (c) is incorrect. Since the property was only worth $80,000 and the debt was $85,000, George and Ellen potentially would have $5,000 of debt cancellation income IF the lender forgave the debt. But if they remain liable for the balance of the debt, they have no debt relief income, making (d) the correct answer. Refer to the text on pages Q7 This question asks which of the following answers is NOT correct. From Price Reduced After Purchase in the text, we see that if the debt owed the seller for the purchase of property is reduced by the seller at a time when the taxpayer is not insolvent and the reduction does not occur in a title 11 bankruptcy case, the reduction does not result in cancellation of debt income. Therefore, answer (a) is a correct statement. Where debt relief is intended as a gift, no income arises. The lender may have to file a gift tax return. Therefore, answer (b) is a correct statement. If a partnership s liability is discharged, the partnership allocates the income from discharge of debt to the partners as a separately stated item. The debt relief is thus reported on Form 1040 by the partners. Available exclusions are also applied at the partner level. Therefore, answer (c) is a correct statement. Sometimes interest is forgiven and included in the amount of canceled debt. If the interest would not be deductible, such as on a personal loan, and none of the other exclusions apply, the interest included in the canceled debt would be taxable. If the interest would be deductible, the interest is not included in debt relief income. Thus, choice (d) is an incorrect statement, and the correct answer to the question. See page 10. Q8 Section 108 specifically excludes debt relief income for taxpayers in a Title 11 bankruptcy. Therefore, answer (d) is not applicable. See page 12. Debts that arise from farming operations do not give rise to debt relief income. Therefore, answer (b) is not applicable. Taxpayers (other than corporations) may exclude debt forgiveness from Qualified Real Property Business Indebtedness. Generally, this refers to debt incurred or assumed in connection with real property used in a trade or business and secured by the property. For this purpose, rentals are trade or business property. Any debt existing on 01/01/93 and secured by the property qualifies. For debts incurred after 01/01/93, the provision applies only to acquisition debt, although the debt may be refinanced to an amount no greater than the outstanding balance of acquisition debt at the date of refinance. Since rental property is considered a trade or business property for this exclusion, answer (c) is not applicable. The real property in answer (a) was acquired in 2000; therefore, equity debt that is forgiven would not qualify for the qualified real property business indebtedness exclusion, making (a) the correct answer. See page 10 14

17 Debt Relief & Insolvent Taxpayer Exclusion Q9 - Farm debt involves special requirements for both the debtor and the lender. The debt must arise from running a farm business--more than 50 percent of the taxpayer s gross receipts for the 3 prior years must be from farming. Therefore, answer (a) is not correct. There is no limit on the length of time the taxpayer may be in the farming business. Thus (b) is not correct. The lender can t be the same person that sold the property in question to the farmer. So, choice (d) is not correct. The lender must be unrelated to the borrower. Thus, choice (c) is the correct answer. See page

18 Debt Relief & Insolvent Taxpayer Exclusion Step #4 Home mortgage debt forgiveness rule? Included in the Mortgage Forgiveness Debt Relief Act of 2007 is the provision that allows taxpayers to exclude home debt forgiveness income from their income. The following is an overview of the provision: Effective: For tax years 2007 through 2012 Exclusion: Up to $2 Million ($1 Million MS) Home: Principal Residence Only (same definition as for Sec 121 gain exclusion rules) Debt: Acquisition Debt Only Basis of Home: Reduced by the amount of the exclusion if retained after relief Caution The exclusion does not apply to a taxpayer s designated 2 nd (vacation) residence. Also, the exclusion doesn't apply to the discharge of a loan: If the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the taxpayer's financial condition. Of a taxpayer in a Title 11 bankruptcy. (Code Sec. 108(h)(3)) Caution The exclusion only applies to the discharge of qualified principal residence acquisition debt. Thus equity debt is not included as part of the exclusion. Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing doesn't exceed the amount of the refinanced indebtedness. (Joint Committee on Taxation, JCX-86-07) Ordering rule - The principal residence exclusion takes precedence over insolvency exclusion unless elected otherwise (Code Sec 108(a)(2)(C)). If only a part of a loan is qualified principal residence indebtedness, the exclusion from income for canceled qualified principal residence indebtedness applies only to the extent the amount canceled exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another Sec 108 exclusion. Basis Adjustment - If the taxpayer excludes canceled qualified principal residence indebtedness from income and continues to own the residence after the cancellation, the taxpayer must reduce the basis of the residence (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Enter the amount of the basis reduction on line 10b of Form 982. Electing Out of Mortgage Relief Exclusion - An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the Code Sec. 108(a)(1)(B) exclusion for insolvent taxpayers. (Code Sec. 108(a)(2), as amended by Act 2(c)) Thus, where a taxpayer has significantly tapped the equity in the home, and has a significant amount of debt discharge that does not qualify for the exclusion, it may be to their advantage to forgo the mortgage relief exclusion and instead use the insolvent taxpayer exclusion. Step #5 Reduce tax attributes (if any) by the excluded amount Whenever a debt relief exclusion is allowed, the affected taxpayer must reduce his tax attributes to the extent of the debt relief. If a taxpayer does not have any tax attributes he still gets the exclusion. Tax attributes are generally NOLs, loss carryovers, credit carryovers, and basis of assets. A reduction of tax attributes is a form of income deferral which means the taxpayer will experience a tax impact sometime in the future. 16

19 Debt Relief & Insolvent Taxpayer Exclusion The first step to attribute reduction is to prepare the return for the year of the debt relief. The tax attributes to be reduced are those left AFTER the return is completed. Tax attributes are reduced in this strict order: (1) NOLs are reduced before any carryovers to the year of debt relief. (2) General business credit carryovers are reduced, $1 for each $3 of debt relief. (3) Minimum tax credits, also reduced $1 for each $3 of debt relief. (4) Capital losses. (5) Basis of assets is reduced at the beginning of the year following the year of debt cancellation, based on the assets owned at that time. Here again, there is a strict ordering for which property bases get reduced first: (a) Trade or business property purchased with the proceeds of the debt which was forgiven; (b) Trade or business property securing the loan; (c) All other trade or business assets; (d) Inventory and notes and accounts receivable; (e) Property held for investment; (f) Other assets. The limit for basis reduction under the bankruptcy or insolvency rule is the extent to which basis of assets after debt relief exceeds liabilities after the debt relief. This limit will not apply if the taxpayer elects to reduce basis first (see special election (1) below). (6) Suspended passive losses. Reduce the suspended passive activity losses $1 for each $1 of excluded debt relief; reduce suspended passive loss credits by $1 for each $3 of excluded debt relief. (7) Foreign tax credit carryovers, one dollar of credit for each three dollars of debt relief. Special notes: If, after going through the sequence shown above, the taxpayer surrenders attributes with a total value of LESS than the excludable debt relief, the balance of the debt relief is forgiven and there is never a tax impact. During a Chapter 11 bankruptcy, any property exempt under Chapter 522 or Title 11 can t have its basis reduced. When property whose basis has been reduced under these rules is subsequently sold, any gain attributable to basis reduction is taxed as ordinary income. Qualified farm debt gets a special rule and there s another sequence when reducing basis. First reduce the basis of depreciable property, then land held for farming use, and lastly other qualified property (which includes property held for investment). When individuals file for bankruptcy, their non-exempt assets are taken into the bankruptcy estate. The reduction of tax attributes rules apply only to the assets within the estate, and any elections are made by the trustee. Two special elections are available when reducing tax attributes: (1) A taxpayer can make an election to reduce basis first. This election is reported on Form 982 and allows a taxpayer to reduce basis of depreciable assets first, rather than in the normal sequence (fifth). If this election is chosen, the limit for basis reduction is the adjusted basis of the assets just after the tax year of the debt discharge. (2) Dealers in real property may elect to treat real property held for sale in the ordinary course of business as depreciable. This election must be made on the original return for the year of debt forgiveness and can only be revoked or elected on a later return with reasonable cause and IRS consent. 17

20 Debt Relief & Insolvent Taxpayer Exclusion EXAMPLE - Working With Debt Forgiveness - Tom Smith is in financial difficulty but has been able to avoid declaring bankruptcy. He reached an agreement with creditors and they agreed to forgive $10,000 of his debt in return for his setting up a payment schedule for the balance. Just before the cancellation, Tom s liabilities were $120,000 and the value of his assets was $100,000 (his basis in these assets was $90,000). He was insolvent by $20,000 and since this exceeds his $10,000 of debt cancellation, he may exclude from income the entire $10,000. Among his assets, the only depreciable one is a rental condo with adjusted basis of $50,000 ($40,000 building and $10,000 for the land). He had a net capital loss from stocks of $5,000, and an NOL carryover to the year of $3,000. His AGI before considering these losses or the debt cancellation is $20,000. He does not itemize and has no other losses nor any credits. Tom completes his tax return. On the return, he will use up the NOL carryover and $3,000 of the capital loss. The only attribute remaining is now the $2,000 capital loss carryover. He would have to give this up but when he reached the step of basis reduction, he would not have to reduce the basis of the rental because he lacks basis equity. He has given up only a $2,000 capital loss carryover, conserved the basis of his rental, and been allowed full exclusion of the $10,000 of debt relief. Special circumstances might cause Tom to prefer either of these treatments. TOM S RETURN: Tom writes SEE FORM 982 on the Other Income line of Form 1040, and enters $0 (ZERO) on that line. He must attach a statement describing the cancellation, a calculation of his insolvency, and Form 982 to the return. Step #6 Complete IRS Form 982 CAUTION Filing Form 982 is a timely filed election. Part I Check the appropriate box and fill in the amount of the exclusion Line 1b is used for most insolvency cases involving non-business debt: Credit card debt Car loans Home loans (to the extent not included on line 1e) Line 1c for discharge of farm indebtedness Line 1d for discharge of real property business indebtedness Line 1e for special rule for discharge of qualified principal residence indebtedness Line 2 - Enter the amount of discharged debt that is being excluded by either the insolvency exclusion or the special rule for qualified principal residence indebtedness On the Other Income line of the taxpayer s 1040 enter Form 982 and any remaining taxable debt relief income after applying the exclusion. If all the debt relief income was excluded enter zero. 18

21 Debt Relief & Insolvent Taxpayer Exclusion Part II This part is completed only if the taxpayer has tax attributes that must be reduced by the amount of the excluded debt relief or when the special rule for qualified principal residence indebtedness applies. If box 1e in part I was checked, this line in part II must be completed. California conforms to the insolvent taxpayer exclusion. A bill passed by the California legislature conforms California personal income tax law to federal amendments made by the Mortgage Forgiveness Debt Relief Act of 2007 (Public Law ) that allow a taxpayer to exclude from gross income the discharge of qualified principal residence debt in calendar years 2007 through However, there are the following differences: 19

22 Debt Relief & Insolvent Taxpayer Exclusion o o The California exclusion to discharge indebtedness applies in calendar years 2007 and 2008 only. The amount of the California exclusion is limited to $250,000 ($125,000 for married filing separately). o Only up to $800,000 ($400,000 for married filing separate) of qualified principal residence indebtedness applies for the purposes of the exclusion, rather than the $2 million ($1 million for married filing separately) limitation provided under federal law. Comparative Example: Federal California Acquisition Debt $1,000,000 Equity Debt $ 200,000 Total Recourse Debt $ 1,200,000 1,200,000 Home s FMV <500,000> <500,000> Debt Relief Income $ 700,000 $ 700,000 Equity Debt (Non-Qualified) <200,000> Recourse Debt $1,200,000 California Max Qualified Debt 800,000 California Non-Qualified <400,000> Excludable $500,000 $300,000 California Debt Relief Maximum $250,000 The exclusion is applicable for California personal income tax purposes beginning with the 2007 taxable year. (S.B. 1055, as enrolled, August 19, 2008) CAUTION Practitioners should carefully analyze the option between gain and insolvent taxpayer exclusions for California purposes keeping in mind the federal and state treatments do not need to be the same. 20

23 Debt Relief & Insolvent Taxpayer Exclusion Review Questions Read and answer the following review questions. The correct answers are found below the review questions with an explanation. 10. Which statement is correct regarding an insolvent taxpayer who has home mortgage debt forgiven and wishes to exclude the income from being taxed? The taxpayer: a. May choose to use either the insolvency exclusion or the home mortgage debt relief exclusion. b. Must use the home mortgage debt relief exclusion. c. Must use the insolvency exclusion. d. May use both the insolvency and home mortgage debt relief exclusions. e. None of the above. 11. Which of the following is a requirement related to the exclusion of home mortgage debt relief? a. The home was purchased after 2006 and before b. The debt relief occurred in tax years 2007 through c. The loan was acquisition debt for either the taxpayer s principal residence or vacation home. d. The loan was equity debt for the taxpayer s principal residence. e. The taxpayer filed for bankruptcy protection. 12. For an individual who uses the single filing status, the maximum amount of income that is excludable under the special home mortgage debt relief exclusion is: a. $500,000 b. $1,000,000 c. $1,500,000 d. $2,000,000 e. No limit 13. A taxpayer who excludes debt relief income under one of Sec. 108 s exclusions must reduce certain tax attributes. Which of the following is not a tax attribute for this purpose? a. Minimum tax credits b. Child tax credit c. Net operating loss d. Suspended passive losses e. All of the above 21

24 Debt Relief & Insolvent Taxpayer Exclusion 14. Two years ago a taxpayer had $2,000 of debt relief income resulting from the forgiveness of debt when his vehicle was repossessed. He qualified for the insolvency exclusion, and in accordance with the tax attributes reduction rule, he reduced the basis of a vacant lot he had purchased in 1995 that he held for investment purposes. He paid $10,000 for the lot. In the current tax year he sells the lot for $15,000. What is the gain and how is it treated? a. $5,000 long-term capital gain. b. $7,000 long-term capital gain. c. $5,000 long-term capital gain and $2,000 ordinary income. d. $7,000 ordinary gain. e. None of the above 15. IRS Form 982 is used for all of the following purposes, except to: a. Calculate the ordinary income resulting from debt relief. b. Claim the insolvency exclusion. c. Claim the exclusion for debts discharged in bankruptcy. d. Show the reduction of tax attributes. e. None of the above. 22