The C, Insolvency, and the Cancellation of Debt: What you Need to Know

Transcription

1 Moving Your Practice in the Right Direction TM The C, Insolvency, and the Cancellation of Debt: What you Need to Know A Practice Essentials Presentation 2010 OnePath Practice Management Advisors, LLC. All Rights Reserved. 1

2 Disclaimer! This is a Continuing Legal Education (CLE) presentation, and it is not legal advice. This presentation was prepared for information purposes only for other lawyers only and deals with hypothetical or historical situations. The information is certainly not intended and should not in any way be construed as legal advice. Your receipt of this information does not in any way create an attorney-client relationship and cannot substitute for obtaining legal advice from an attorney. The presenter makes no claim about the correct interpretation of any law discussed in this presentation. The presenter does not make any claim about what the correct course of action might be in a particular matter. The presenter also does not make any claim that the information contained in this article is complete or correct. 2

3 About the Presenter! Benjamin Stolz, Esq. is trainer, speaker, educator, writer and attorney with over 20 years experience practicing consumer bankruptcy and business law, managing and advising small businesses. Ben received his BA from the University of South Florida, with Departmental Honors, and a JD from Southern Methodist University. He has been admitted to practice in Texas both before the Supreme Court of Texas, all lesser Texas courts, as well as the United States District Courts for the Northern and Eastern Districts of Texas. Ben is a member of the National Association of Consumer Bankruptcy Attorneys (NACBA), the American Bankruptcy Institute (ABI), Association of Litigation Support Professionals (ALSP), the American Bar Association (ABA), a proud graduate of the Max Gardner Bankruptcy Boot camp,!and a frequent guest panelist at Consumer Bankruptcy CLE events. As a result of his ongoing commitment to continuing legal education, Ben was also admitted in 2009 to the College of the State Bar of Texas, an Honorary Society chartered by the State Bar of Texas. 3

4 The Sea of Debt! The United States is awash in a sea of debt. In June 2009, there was more than $14 trillion of mortgage debt outstanding approximately $11 trillion on one to four family residences, approximately $900 billion on multifamily residences, slightly more than $2.5 trillion on nonfarm nonresidential real estate, and $111 billion on farms.! Over $2.5 trillion dollars of consumer debt was outstanding as of May of At the end of June of 2009, over $ 1.2 trillion of commercial paper was outstanding. At the end of the first quarter of 2009, over $11 trillion of nonfinancial business debt, approximately $7.2 trillion of which was owed by corporations, was outstanding.!!!!!!!!!!!! 4

5 The Sea of Debt! Setting the Stage for Widespread Cancellation of Debt Problems! Major corporations, such as the American icon General Motors, have been unable to pay their debts and have gone into bankruptcy.! Millions of individuals and small businesses have defaulted on their debts.! Loan delinquencies and charge-offs are at levels never before seen in modern times.!!!!!!!!!!!! 5

6 Every Cause has an Effect! According to the Federal Reserve Board, bank loan charge-off rates more than quadrupled from the first quarter of 2006 to the first quarter of 2009; the charge off rate in the first quarter of 2009 exceeded 2%.! In that same period, loan delinquency rates more than tripled and stood at 5.6% in the first quarter of Almost 8% of residential real estate loans and 6.4% or commercial real estate loans were in default.! In the spring of 2009, the Mortgage Bankers Association reported that the share of loans entering foreclosure rose to 1.37%, the highest on record going back to The number of bankruptcies filed in 2008 totaled 1,117,771, up from 850,912 bankruptcies filed in 2007.!!!!!!!!!!!! 6

7 Every Cause as an Effect! Every loan charge-off and mortgage foreclosure has tax consequences.! While the creditor most often claims a bad-debt deduction or business-related loss, the debtor generally must recognize gross income and pay income taxes on an amount roughly equal to the creditor s loss, unless a special exception applies to exclude the debt relief from income.! Almost every form of gross income required to be included under section 61 entails the receipt of money, property, or services of value (or the accrual of the right to receive money, property, or services in the year of receipt).! The requirement that a debtor pay taxes when a loan goes unpaid is one of only a few situations in which a tax obligation arises without the contemporaneous receipt of valuable consideration. That the debtor must pay taxes in the year in which it is determined that a loan will not be repaid follows from the proposition that a borrower is not required to include loan proceeds in gross income upon receipt and thus not required to pay taxes at that time. 7

8 What we are going to Learn Today! This presentation deals with the tax consequences to the debtor of the discharge of a debt for less than full payment.! The course addresses Section 61(a)(12) of the Internal Revenue Code (IRC) dealing with Income from discharge of indebtedness.! Attendees will review Form 1099-C and learn the differences between a Form 1099-C and 1099-A.! Attendees will also review Section 6050P of the IRC as it affects certain financial institutions and government agencies and learn how Cancellation of Debt (COD) income can arise from credit card debt, auto loans, student loans and home mortgage debts.! Attendees will further review the basics of Recourse and Non-Recourse debt, and factor in the significance of Deductible Debt addressed under Section 108(e)(2) of the IRC.! Attendees will review the impact of the Mortgage Forgiveness Debt Relief Act of 2007 and successor laws that impact families electing to leave the keys in the mailbox and walk away.! Finally, Attendees will learn about insolvency and bankruptcy proceedings as they relate to COD income, learn how to calculate insolvency and learn about the effects of tax attribute reduction. 8

9 Cancellation of Debt Section 61! Section 61(a)(12) of the Internal Revenue Code (IRC) provides that gross income includes income from discharge of indebtedness.! Example: John Q. Taxpayer borrows $10,000 from First National Bank in When that loan comes due in 2010, Mr. Taxpayer is able to repay only $7,500. First National discharges the remaining balance. Mr. Taxpayer has $2,500 of cancellation of debt (COD) income. 9

10 Why did I get a 1099-C?! Section 6050P of the IRC requires certain financial institutions and federal agencies that cancel a debt of $ or more during any calendar year to file an information return (Form 1099-C) with the IRS and provide a copy to the taxpayer whose debt was cancelled.! Even if you did not receive a Form 1099-C, you must report canceled debt as gross income on your tax return unless one of the exceptions or exclusions described later applies.! An applicable financial entity includes:! A federal government agency,! A financial institution,! A credit union, or! Any organization a significant trade or business of which is lending money. 10

11 Why did I get a 1099-C?! Under what circumstances can COD arise? The following is a non-exclusive list of the most common situations that your client s will experience:! Credit Card (debt workouts and settlements)! Repossessions! Cancellation of a Student Loan*! Foreclosures! Property Abandonment, and even! Stockholder debt.!!if you are a stockholder in a corporation and the corporation cancels or forgives your debt to it, the canceled debt is a constructive distribution that is generally treated as dividend income to you 11

12 Student Loans (in detail)! Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers.! If your student loan is canceled as the result of this type of provision, the cancellation of this debt is not included in your gross income. To qualify for this treatment, the loan must have been made by:! The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof,! A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or! An educational institution (defined later):! Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or! As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization (defined later).! A loan to refinance a qualified student loan also will qualify if it was made by an educational institution or a tax-exempt section 501(a) organization under its program designed as described in (3)(b) above. 12

13 What about interest on debt?! Interest included in canceled debt.!!!if any interest is forgiven and included in the amount of canceled debt in box 2 (of Form 1099), the interest portion that is included in box 2 will be shown in box 3. Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it. 13

14 Is all Debt Created Equal? No.! Non-Recourse Debt! Nonrecourse debt or a nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral 14

15 Is all Debt Created Equal? No.! When nonrecourse debt is canceled:! By reason of the disposition of property, no COD income is realized; instead, the full amount of the debt is included in the amount realized on the disposition, but no CODI. See Treas. Reg. section (c), Ex. 7.! Problem: In a workout (i.e., without transfer of underlying property), COD income can arise. See Rev. Rul ; Rev. Rul

16 Is all Debt Created Equal? No.! Recourse Debt! Recourse debt is a debt that is not backed by collateral from the borrower. Also known as a recourse loan, this type of debt allows the lender to collect from the debtor and the debtor's assets in the case of default as opposed to foreclosing on a particular property or asset as with a or auto loan. Nonpayment of recourse debt allows the lender the right to collect assets or pursue legal action.! Note: While mortgages in the US are typical nonrecourse debt, a foreclosure or bankruptcy can trigger the loan to become recourse debt at the request of the lending institution. 16

17 Is all Debt Created Equal? No.! Recourse Debt! If a debt for which Mr. Taxpayer is personally liable is discharged as a result of a foreclosure, sale, or other disposition of property that secures the debt, he may realize gain or loss on the disposition as well as COD income.! (1) In the case of personal use property, such as a principal residence, any loss would be nondeductible.! (2) The amount realized by Mr. Taxpayer would be the smaller of the FMV of the residence or the outstanding debt immediately before the transfer. 17

18 Is all Debt Created Equal? No.! What about a Loan Modification! Discharge of recourse debt in a loan modification would result in no gain or loss, but COD can arise!! See Revenue Ruling 91-31; Revenue Ruling ! If a lender offers to discount (reduce) the principal balance of a loan if the loan is paid off early, or agrees to a loan modification (a workout ) that includes a reduction in the principal balance of a loan, the amount of the discount or the amount of principal reduction is canceled debt whether or not you are personally liable for the debt.! The amount of the canceled debt must be included in income unless one of the exceptions or exclusions described later applies. 18

19 Deductible Debt! Section 108(e)(2) provides that no COD income is realized to the extent that payment of the debt would have given rise to a deduction.! What about Mortgage interest?! generally deductible under section 163(h)(3).! What about Interest on other types of consumer debt?! credit card debt, automobile financing generally is nondeductible personal interest under section 163(h)(2). 19

20 Price Reduced after Purchase! If debt you owe the seller for the purchase of property is reduced by the seller at a time when you are 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, you must reduce your basis in the property by the amount of the reduction of your debt to the seller 20

21 Tax Deferred CODI under 108! COD income can arise in a debt workout as well as in a foreclosure. But, whether COD income is taxable depends on whether an exception in 108 applies.! Section 108 of the IRC excludes discharges of indebtedness from gross income if:! Discharge occurs in bankruptcy! Discharge occurs while Mr. Taxpayer is insolvent! The Debt is qualified farm indebtedness! The Debt is a student loan for which the exclusion provided by 108(f) applies, or! Certain businesses repurchasing their own debt*! The debt is qualified principal residence indebtedness 21

22 Tax Deferred CODI under 108! Insolvency Exclusion! Exclusion only applies to the extent of insolvency.! How to calculate Insolvency! Total liabilities immediately before the discharge - FMV of total assets* before the discharge determines the extent to which the taxpayer is insolvent.! Note: The Insolvency calculation Includes exempt assets (e.g., retirement account and interest in a pension plan). 22

23 The Mortgage Forgiveness Debt Relief Act of 2007! The Act created a new exclusion under 108(a)(1)(E) and 108 (h) for discharged qualified principal residence indebtedness.! This exception applies to qualified principal residence indebtedness that is discharged on or after January 1, 2007 and before January 1, 2013.! Applies to acquisition indebtedness (as defined in IRC 163 (h)(3)(b) and carries a $2,000,000 limitation (or a $1,000,000 limitation for MFS)! The term Principal Residence is defined under IRC

24 The Mortgage Forgiveness Debt Relief Act of 2007! The Act created a new exclusion under 108(a)(1)(E) and 108 (h) for discharged qualified principal residence indebtedness.! This exception applies to qualified principal residence indebtedness that is discharged on or after January 1, 2007 and before January 1, 2013.! Applies to acquisition indebtedness (as defined in IRC 163 (h)(3)(b) and carries a $2,000,000 limitation (or a $1,000,000 limitation for MFS)! The term Principal Residence is defined under IRC

25 The Mortgage Forgiveness Debt Relief Act of 2007! What is Acquisition Indebtedness under MFDRA?! IRC 163)h)(3)(B) states: Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving the home and is secured by the home.! Acquisition Indebtedness:! May include refinanced debt and the proceeds of a home equity loan used to substantially improve the home; but! Does NOT include a home equity loan used to pay off credit cards, or purchase a car, pay medical bills, etc 25

26 The Mortgage Forgiveness Debt Relief Act of 2007! Ordering Rule! If only a part of the loan is qualified principal residence indebtedness, the exclusion for discharged qualified principal residence indebtedness applies only to the extent the amount discharged exceeds the amount of the loan (immediately before discharge) that was not qualified principal residence indebtedness. 26

27 The Mortgage Forgiveness Debt Relief Act of 2007! Example:! Outstanding mortgage balance = $750,000! Refinanced for $850,000! Additional $100,000 used to buy car & pay credit card debt! Lender forecloses, sells the house for $735,000, and cancels the remaining $115,000 of debt.! Ordering rule:! $115,000 canceled debt! $100,000 of nonqualified debt $15,000 amount eligible for exclusion as QPRI NOTE: The remaining $100,000 must be included in income unless another exception or exclusion applies (e.g., insolvency). 27

28 The Reporting Process! Form 1099-A! When a house is foreclosed upon by the bank, the owners typically receive Form 1099-A from the lender showing several pieces of relevant information.! The information on Form 1099-A will likely be needed to report the foreclosure properly on your tax return.! A foreclosure is treated as the sale of property, and the former property owner will need to calculate their gain or loss on the property. But, unlike a normal sale, there's no "selling price," and this is where the Form 1099-A comes into play. 28

29 The Reporting Process! Under the rules for calculating the tax consequences of a foreclosure (for example), Mr. Taxpayer will need to figure out the selling price so that the gain or loss can be calculated.! Depending on the type of loan, Mr. Taxpayer will utilize either the FMV of the property or the outstanding loan balance on the property for the selling price. Both of these figures are reported on Form 1099-A.! The outstanding loan balance is found in Box 2; the property s FMV is found in Box 4. The date of the foreclosure is indicated in Box 1, and this will be the date used as the date the property was disposed of (that is, the sale date ).! Mr. Taxpayer will also have to know if the loan was a recourse or non-recourse loan; the loan was probably a recourse loan if the bank has checked yes is Box 5, which asks Was borrower was personally liable for the repayment of the debt? 29

30 The Reporting Process! Form 1099-C! Mr. Taxpayer may receive multiple 1099-A Forms (one from each lender) for a single property.! He may also receive a 1099-C instead of a Form 1099-A, if the lender both foreclosed on the property and canceled any mortgage debt for which he was personally liable. 30

31 General Rule: CODI is taxable as ordinary income If the debt is Related to Report Net Taxable Amount on Non-Business Debt Form 1040, line 21 (or Form 1040NR, line 21) Nonfarm sole proprietorship Schedule C, line 6 (or Schedule C-EZ, line 1) Nonfarm rental activity Schedule E, line 3 Farm debt (taxpayer is a farmer) Schedule F, line 10 Farm rental activity for which the taxpayer uses Form 4835 to report rental income based on crops or livestock produced by tenant Form 4835, line 6 31

32 Exceptions and Exclusions: A Recap Exceptions Exclusions Amounts otherwise excluded from income Certain student loans Deductible debt (cash basis) Price reduced after purchase Bankruptcy Insolvency Qualified farm indebtedness Qualified real property indebtedness Qualified Principal Residence indebtedness *AARTA 32

33 Bankruptcy and Insolvency! Bankruptcy! Line1a of Form 982! No other exclusion applies if the debt was canceled in a title 11 bankruptcy case! Insolvency! Line 1b of Form 982! Exclusion limited to the extent of insolvency 33

34 Reduction in Tax Attributes! Reduction of Tax Attributes (in order)! Net operating loss (NOL) and NOL carryover! General business credit carryover! Minimum tax credit! Capital loss and capital loss carryover! Basis! Passive activity loss and credit carryover! Foreign tax credit 34

35 Reduction in Tax Attributes! Example! Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 1995, he reached an agreement with his creditors, whereby they agreed to forgive $10,000 of the total that he owed them, in return for his setting up a schedule for repayment of the rest of his debts.! Immediately before the debt cancellation, Tom's liabilities totaled $120,000 and the fair market value of his assets was $100,000 (his total basis in all these assets was $90,000).! At the time of the debt cancellation, he was considered insolvent by $20,000.! He can exclude from income the entire $10,000 debt cancellation because it was not more than the amount by which he was insolvent. 35

36 Reduction in Tax Attributes! Example (continued)! Among Tom's assets, the only depreciable asset is a rental condominium with an adjusted basis of $50,000.! Of this, $10,000 is allocable to the land, leaving a depreciable basis of $40,000.! He has a long-term capital loss carryover to 1996 of $5,000. He also has a net operating loss of $2,000 and a $3,000 net operating loss carryover from 1994.! He has no other tax attributes arising from the current tax year or carried to this year. 36

37 Reduction in Tax Attributes! Example (continued)! Ordinarily, in applying the $10,000 debt cancellation amount to reduce tax attributes, Tom would first reduce his $2,000 net operating loss, next his $3,000 net operating loss carryover from 1994, and then his $5,000 net capital loss carryover. However, he figures that it is better for him to preserve his loss carryovers for the next tax year.! Tom elects to reduce basis first. He can reduce the depreciable basis of his rental condominium (his only depreciable asset) by $10,000. The tax effect of doing this will be to reduce his depreciation deductions for years following the year of the debt cancellation. However, if he later sells the condominium at a gain, the part of the gain from the basis reduction will be taxable as ordinary income.! Tom must file Form 982, with his individual return (Form 1040) for the tax year of the debt discharge. In addition, he must attach a statement describing the debt cancellation transaction and identifying the property to which the basis reduction applies. 37

38 The American Recovery Act of 2009! On August 17, 2009, the Internal Revenue Service ("IRS") issued Revenue Procedure (the "Revenue Procedure") to provide important guidance on the ability of taxpayers to defer cancellation of debt ("COD") income arising on the reacquisition of their own debt.! The right to defer COD income on reacquired debt -- added by the American Recovery and Reinvestment Tax Act of 2009 (the "2009 Act") --can yield significant tax and related cash flow benefits to taxpayers who are restructuring or negotiating settlements of their indebtedness. 38

39 The American Recovery Act of 2009! The 2009 Act enacted new Section 108(i) of the Internal Revenue Code to allow C corporations and other taxpayers that conduct a trade or business to elect to delay recognition of COD income arising from their or a related party acquisition of its own debt in 2009 or 2010 (the "Section 108(i) Election").! COD income subject to the election is deferred until 2014 and then included in income ratably over 5 years.! A reacquisition of debt that is eligible for the Section 108(i) Election includes a (i) purchase for either cash or property, (ii) recapitalization of old debt in exchange for new debt or equity, (iii) contribution to capital, and (iv) forgiveness or cancellation of indebtedness by the holder.! The election applies to COD income from the taxpayer's bonds, debentures, notes, certificates, or any other instrument or contractual arrangement constituting indebtedness for income tax purposes (referred to as "an applicable debt instrument"). 39

40 The American Recovery Act of 2009! The 2009 Act enacted new Section 108(i) of the Internal Revenue Code to allow C corporations and other taxpayers that conduct a trade or business to elect to delay recognition of COD income arising from their or a related party acquisition of its own debt in 2009 or 2010 (the "Section 108(i) Election").! COD income subject to the election is deferred until 2014 and then included in income ratably over 5 years.! A reacquisition of debt that is eligible for the Section 108(i) Election includes a (i) purchase for either cash or property, (ii) recapitalization of old debt in exchange for new debt or equity, (iii) contribution to capital, and (iv) forgiveness or cancellation of indebtedness by the holder.! The election applies to COD income from the taxpayer's bonds, debentures, notes, certificates, or any other instrument or contractual arrangement constituting indebtedness for income tax purposes (referred to as "an applicable debt instrument"). 40

41 Revenue Procedure ! The Revenue Procedure provides administrative guidance including the timing and manner for making the election as well as specific procedures for partnerships, S corporations, tiered-pass-through entities and foreign entities.! Extended dialog on this topic is beyond the scope of this discussion; however, a copy of the Guidance is attached. 41

42 Questions?! Q&A! A question and answer session will follow this presentation; however, if you prefer you may submit questions to questions@onepathlpm.com.! Your instructor will reply to all questions following the conclusion of the presentation. In some cases, responses may be briefly delayed due to the volume of questions received.! Forum! You may also join a Forum where this subject material will be discussed. Admission is free. We look forward to seeing you there.! The Forum is limited to attorneys and instructors an may be accessed by navigating to and clicking the Forum tab in the upper right. Simply register using the box in the lower left. 42