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2 This publication is distributed with the understanding that the authors and publisher are not engaged in rendering legal, accounting or other professional advice and assume no liability in connection with its use. Tax laws are constantly changing and are subject to differing interpretation. In addition, the facts and circumstances in your particular situation may not be the same as those presented here. Therefore, we urge you to do additional research and ensure that you are fully informed before using the information contained in this publication. Federal law prohibits unauthorized reproduction of the material in Spidell s Cancellation of Debt The Next Step manual. All reproduction must be approved in writing by Spidell Publishing, Inc. This is not a free publication. Purchase of this electronic publication entitles the buyer to keep one copy on his/her computer and to print out one copy only. Printing out more than one copy and any electronic distribution of this publication is prohibited by international and United States copyright laws and treaties. Illegal distribution of this publication will subject the purchaser to penalties of up to $100,000 per copy distributed.

3 Cancellation of debt the next step Cancellation of debt... 1 What is discharge of debt?... 1 Debt assumed in divorce... 2 Military members motor vehicle leases... 3 Foreclosures and short sales... 3 Sales proceeds or cancellation of debt income?... 3 Recourse and nonrecourse... 4 So, is the loan recourse or nonrecourse?... 4 The bifurcated approach to recourse debt... 4 The one-step sales approach to nonrecourse debt... 6 Two debts one nonrecourse, one recourse... 6 Using IRC 121 in a foreclosure... 7 The qualified principal residence exclusion... 8 When a portion of the mortgage is not qualified principal residence indebtedness... 9 Coordination with other provisions California s debt relief provisions and 2008 provisions Other COD provisions Exclusion from income IRC The bankruptcy exclusion The insolvency exclusion When is a taxpayer insolvent? Assets for purposes of the insolvency exclusion Nonrecourse debt and insolvency Insolvency and residence exclusion Electing the insolvency provisions over residence exclusion Using both the residence and the insolvency exclusions The qualified farm indebtedness exclusion The exclusion for cancellation of student loans Loan repayment programs The exclusion for discharge of qualified real property business indebtedness Does rental property qualify for the exclusion? Limitations on exclusion Depreciable basis limitation Applying the basis reduction Special rules for partnerships and S corporations Property converted from personal to business use, or vice versa Deferral of income on repurchased debt (IRC 108(i)) Reacquisition Acceleration of deferred items Passthrough entities IRS provides guidance (Rev. Proc ) California nonconformity Reduction of tax attributes Coordinating the 108 relief provisions with each other and with IRC i Spidell Publishing, Inc.

4 Reporting the COD Form 1099-C Form 1099-A Incorrect forms Preparing the returns Preparing the California return Cancellation of debt and residency Income from real property Credit card debt Repossession the other side of foreclosure Calculating gain on the repossession Repossession of former principal residence Basis of repossessed property Appendix Checklist for Exclusion of COD Income Resulting from Cancellation of Home Mortgage Indebtedness Glossary... 1 Index... 2 Spidell Publishing, Inc. ii 2010

5 CANCELLATION OF DEBT One in every 138 U.S. housing units received a foreclosure filing during the quarter of 2010, according to RealtyTrac.com, a Web site that compiles default notices, auction sales, and bank repossessions across the United States. In California, one in every 62 housing units received a foreclosure filing, resulting in the nation s fourth highest foreclosure rate. However, that ranking is based on a percentage of homes in the state. When discussing sheer numbers, California leads the way. California alone accounted for 23% of the nation s total foreclosure activity in the first quarter of To help mitigate this tsunami of foreclosures, Congress has provided sandbags in the form of tax relief. Effective for discharges of indebtedness on or after January 1, 2007, and before January 1, 2013, the Mortgage Forgiveness Debt Relief Act of 2007 ( the Act ) excludes from a taxpayer s gross income a qualifying discharge (in whole or in part) of qualified principal residence indebtedness. (IRC 108(a)(1)(E)) However, not all taxpayers in foreclosure will qualify for the benefits of the Act. Moreover, California has only partially conformed. Fortunately, there are also old laws addressing these same old problems. As such, even if a taxpayer cannot enjoy the benefits of the residence exclusion provision of the Act, the taxpayer may be entitled to exclude income on a foreclosure or short sale under other provisions of the tax law to which California does conform. In this discussion, we ll address the following in order: Discharge of debt including the important distinction between cancellation of debt income (COD) and sale treatment; The critical difference between recourse and nonrecourse debt and the different tax treatment accorded to each; The exclusion for principal residences under IRC 108(h); Utilizing IRC 121 on the foreclosure of a principal residence; Utilizing the longstanding provisions of IRC 108; Reduction of tax attributes; Coordinating the old and new 108 relief provisions with each other and with IRC 121; Reporting the transaction; and Repossession. We will also discuss California issues such as nonconformity and residency issues. WHAT IS DISCHARGE OF DEBT? Under the IRC and Treasury Regulations, there is no real definition of cancellation of debt (COD) income. However, it is firmly established that a taxpayer may realize income from discharge of indebtedness. (IRC 61(a)(12), Treas. Regs (a), U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931)) Spidell Publishing, Inc.

6 Discharge of debt occurs when a taxpayer is released from indebtedness in whole or in part. A debt may be discharged when: A taxpayer buys back the debt for less than the face amount; A creditor and debtor agree to settle the debt for less than the full amount owed; A creditor simply cancels/discharges the total debt; Debt is discharged in bankruptcy; The state statute of limitations expires; or A lender forecloses on the property. Practice Pointer A debt is considered discharged or canceled at the moment it becomes clear that the debt will never have to be repaid based on the likelihood of payment or the worthlessness of the debt. To look at it another way, a debt is not considered discharged as long as there is a reasonable prospect that payment will occur. (IRC 108(e)(2)) The amount of debt forgiven does not include any amount forgiven that would have given rise to a deduction. Thus, in the case of a cash basis taxpayer with a loan with negative amortization or accrued but unpaid interest, the amount of unpaid interest is not treated as an amount forgiven (and cannot be taken as a deduction). In the case of an accrual basis taxpayer that previously deducted the interest or a portion of it, the amount previously deducted must be included in income in the year of discharge. (IRS Publication 525) Example of unpaid interest George bought real property with a $500,000 mortgage and was paying interest only. When the property value dropped to $400,000, George stopped making payments until the bank foreclosed and took the house. At the time that the bank foreclosed on the house, George owed $500,000 in principal and $75,000 in unpaid interest. George s debt forgiveness is $100,000 ($500,000 - $400,000). The interest is not part of the forgiven debt and he may not deduct the $75,000 as an interest expense. Debt assumed in divorce A taxpayer received cancellation of debt income from a loan that was assumed by his exwife pursuant to their divorce decree. (Jensen v. Comm. TCM ) Although the decree stated that the ex-wife was responsible for the debt in question, and that the husband had indemnification rights against the ex-wife for the debts and any costs associated with them, the husband was not relieved of liability by the lender. Because the husband was liable to the bank for the debt, he incurred COD income when the debt was canceled. Caution Many divorcing taxpayers are having trouble refinancing homes that are underwater. Because the loans can t be refinanced, this is a problem that your clients could encounter if they remain liable for a debt, even though the divorce decree says the ex-spouse must make the payments. Spidell Publishing, Inc

7 Military members motor vehicle leases If a member of the military enters into a vehicle lease, and is later deployed for a period of not less than 180 days, he or she may terminate the lease without recognizing income. ( 305(a) of the Servicemembers Civil Relief Act) The lessor is also prohibited from charging an early termination fee. Because the servicemember owes nothing, and doesn t have any discharge of indebtedness income, the lessor should not issue a 1099-C. FORECLOSURES AND SHORT SALES Foreclosure is an equitable proceeding in which a bank or other secured creditor sells or repossesses a secured asset due to the owner s failure to comply with the terms of the loan agreement or mortgage. Short sales are becoming more common. In a short sale, the lender and creditor agree to let a third party purchase the property for less than the loan balance, and the lender agrees to cancel the balance of the debt. This may be a win-win situation. The borrower avoids having a foreclosure on his or her credit record, and the lender avoids the costs of foreclosure. Example of a short sale Fred s house has a fair market value of $450,000 and his mortgage stands at $550,000. Fred finds a buyer willing to pay $450,000 and the bank agrees to the short sale in satisfaction of the $550,000 mortgage balance. Fred avoids a foreclosure going on his credit report and the bank avoids the cost of foreclosure. SALES PROCEEDS OR CANCELLATION OF DEBT INCOME? A discharge of debt may produce COD income or may be considered proceeds from the sale of the property securing the debt. The type of income depends on: Whether there is property securing the debt; and The type of debt securing the property (nonrecourse or recourse) and whether the property securing the debt is given up. No property securing the debt: COD income. This is the ordinary situation of a loan forgiven or discharged at less than full value. Buyer retains property: Reduction of debt, without the surrender of the related property, results in COD income. (IRC 61(a)(12)) Such income may arise when a lender reduces the principal amount of the debt in a loan modification. Buyer loses or gives up property: Satisfaction of a debt by surrender of the property is treated as a sale. (Treas. Regs ) However, if the FMV of the underlying property does not satisfy the debt, the transaction may also result in COD income if the debt is recourse. In this case, nonrecourse debt can only give rise to sale treatment when the property is transferred. There is no COD income. The lender, after all, has no recourse to any assets except the secured property. Instead, the transaction is treated as a sale or exchange of the property. The amount realized is the greater of the principal amount of the debt or the fair market value of the property. (Comm. v. Tufts, 461 U.S. 300 (1983); Treas. Regs (a)(1)) Spidell Publishing, Inc.

8 RECOURSE AND NONRECOURSE If the mortgaged loan is recourse, the lender has recourse to assets of the borrower other than solely the assets securing the loan. If the loan is nonrecourse, this doesn t mean the loan is unsecured; however, the lender only has claim to the assets securing the debt. So, is the loan recourse or nonrecourse? A loan is an obligation to pay and must be paid in full. As such, the default answer is that a loan is recourse unless made nonrecourse in one of two ways: By specific terms of the loan making it nonrecourse; or By operation of law. California s anti-deficiency laws prohibit secured lenders, under certain circumstances, from pursuing the borrower for the unpaid balance when the proceeds from a foreclosure sale do not fully pay the amount of the borrower s secured debt. So, when the anti-deficiency laws apply to certain protected borrowers, lenders will be barred, generally, from pursuing the borrowers personally for any excess amount of the secured debt left unpaid after a foreclosure sale (the deficiency ). California law specifically prohibits recovery of a deficiency from a borrower, who incurred the loan in order to purchase real property as a residence for the debtor, when the property contains one to four units and the property was used to secure the purchase loan. (Code of Civil Procedure 580b) Accordingly, a loan to purchase a principal residence is, by California law, nonrecourse. However, a refinanced loan is very likely recourse unless the terms of the loan make it nonrecourse. Caution We ve been in the habit of thinking of recourse loans as de facto nonrecourse because in recent years, lenders have not often pursued deficiency judgments at foreclosure. However, these are desperate times, and we ve been hearing reports of more lenders going after deficiency judgments. Keep in mind, too, that if a lender agrees to a short sale, that agreement in and of itself does not prevent the lender from pursuing a deficiency judgment; the lender must explicitly agree to waive the right. Consider these issues, and use extreme caution in advising a client regarding a foreclosure or short sale. THE BIFURCATED APPROACH TO RECOURSE DEBT If property subject to a recourse debt is conveyed to a creditor, the transaction is split into two parts consisting of: 1. A taxable disposition of the property; and 2. Either a continuing debt obligation is owed to the creditor or a discharge of the remainder of the liability, to the extent that the value of the property is less than the recourse liability. Spidell Publishing, Inc

9 Under this approach, the taxpayer recognizes gain or loss equal to the difference between the FMV of the property and the taxpayer s adjusted tax basis immediately prior to the disposition. If the remainder of the debt is forgiven, the amount forgiven will constitute COD income which, unless excluded under IRC 108, will be included in the taxpayer s ordinary gross income. When the taxpayer is personally liable for the debt (recourse debt), the lender can go after (has recourse to) the taxpayer s other assets if the FMV of the property taken back is less than the outstanding loan amount. To the extent that the lender releases the borrower from further liability, the borrower will have COD income. (Treas. Regs (a)(2); Rev. Rul ; Bressi v. Comm., TCM , aff d. per curiam 989 F.2d 486 (3d Cir. 1993); James J. Gehl, et ux., 102 TC 784 (1994), aff d. 50 F.3d 12 (8th Cir. 1995)) If the property is encumbered by recourse debt, the taxpayer is required to make two calculations when the property is foreclosed: To the extent that the FMV of the property exceeds the basis, gain or loss on the disposition of the property results. The FMV is treated as the sales price of the property; and To the extent that the indebtedness exceeds the FMV of the property, COD income results. In a foreclosure, the FMV of the property is usually less than the debt forgiven. Example of foreclosure on recourse debt (without regard to the principal residence exclusion) Lila Bility owes Budget Bank $300,000 on her principal residence. The loan is recourse. It is qualified principal residence indebtedness. The value of the property has dropped to $275,000 when her ARM adjusts upward, and she can no longer afford the payments. The property s basis is $250,000. Recourse debt $300,000 FMV (275,000) COD income $ 25,000 FMV $275,000 Basis (250,000) Gain $ 25,000 Sue has $25,000 COD income and $25,000 of gain. The bifurcated approach of recourse debt can produce strange tax circumstances. Example of recourse debt when basis exceeds FMV (without regard to principal residence exclusion) Assume that Lila s property has a FMV of $250,000 and a basis of $275,000. Recourse debt $300,000 FMV (250,000) COD income $ 50,000 FMV $250,000 Basis (275,000) Gain $ (25,000) Sue has $50,000 COD income and $25,000 nondeductible loss on the sale of her personal residence Spidell Publishing, Inc.

10 THE ONE-STEP SALES APPROACH TO NONRECOURSE DEBT There is no COD income triggered on the cancellation of a nonrecourse debt. The only calculation involved when the nonrecourse debt is canceled, is the amount of possible gain or loss on the sale. The amount realized is the greater of: The principal amount of the debt; or The fair market value of the property. Thus, if property subject to a nonrecourse debt is conveyed to the creditor, and the nonrecourse debt exceeds the FMV of the property, the debtor will recognize gain or loss equal to the difference between the amount of the liability discharged (plus the amount of cash and FMV of any property paid to the debtor) and the debtor s adjusted tax basis in the property immediately before the disposition. No portion of the debtor s gain is treated as COD income. Further, the property s FMV is irrelevant to the calculation. (Comm. v. Tufts, 461 U.S. 300 (1983)) Taxpayers with nonrecourse debt do not have COD income when the property is foreclosed. The amount of the debt becomes the sales price in the year that the debt is discharged. Example foreclosure on nonrecourse debt using the principal residence exclusion In the example above, Lila s mortgage is nonrecourse: Nonrecourse debt $300,000 Basis (275,000) Gain $ 25,000 The foreclosure is treated entirely as an exchange with gain. There is no COD income on this foreclosure. TWO DEBTS ONE NONRECOURSE, ONE RECOURSE These days, it is common for taxpayers to have more than one debt securing the residence. In many instances, the first mortgage is nonrecourse, and the second mortgage, perhaps a line-of-credit loan, is recourse. How do you figure the COD income and gain/loss on foreclosure when you encounter this situation? Since one of the loans is a recourse loan, you must use the bifurcated approach discussed above, which means that the COD income is equal to the difference between the amount of the debt and the FMV of the property. But you have two loans, not one, and only part of the FMV of the property is allocable to the recourse debt. How do you solve this problem? You must allocate the FMV of the residence to the particular loans in order to find out how much COD income is attributable to the recourse debt. The FMV is allocated to the debts in the order of their legal priority. Spidell Publishing, Inc

11 Example of foreclosure where one debt is nonrecourse, one debt is recourse (without regard to the principal residence exclusion) Lila Bility has two loans on her principal residence with Budget Bank: a $200,000 nonrecourse first incurred when she purchased the property, and a $100,000 recourse second that she took out to make some improvements. The value of the property has dropped to $275,000 and she can no longer afford the payments. The property s basis is $250,000. Total debt $300,000 FMV (275,000) Debt forgiveness $ 25,000 The FMV of the property must be allocated to the two debts to determine the amount of COD income The solution is to allocate the FMV of the property to the two debts in order of their legal priorities, i.e., allocated to the $200,000 nonrecourse debt, then to the $100,000 recourse debt, because the $200,000 debt would normally be paid off first. Nonrecourse debt $200,000 FMV allocated to nonrecourse debt (200,000) Balance $ 0 Recourse debt $100,000 FMV allocated to recourse debt ( 75,000) COD income $ 25,000 FMV $275,000 Basis (250,000) Gain $ 25,000 Sue has $25,000 COD income, and $25,000 of gain. USING IRC 121 IN A FORECLOSURE To the extent that there is gain from a foreclosure, a taxpayer may use the rules under IRC 121 to exclude some or all of the gain. Under IRC 121, a taxpayer can exclude up to $250,000 of the gain ($500,000 for married filing joint) on the sale of a house if the house is used as the taxpayer s primary residence for two of the past five years, among other requirements. It is important to note the distinction between COD income and gain on the disposition of the taxpayer s principal residence because COD income may not be excluded under IRC 121. Only IRC 108 pertains to exclusions of COD income. IRC 121 applies to the exclusion of gain on the disposition of the residence. Let s revisit Lila Bility. The facts are repeated from one of our earlier examples with additions or changes in bold Spidell Publishing, Inc.

12 Example of gain on foreclosure of a principal residence Lila Bility owes Budget Bank $300,000 on her principal residence. The loan is recourse. It is qualified principal residence indebtedness. The value of the property has dropped to $275,000 when her ARM adjusts upward and she can no longer afford the payments. The property s basis is $250,000. If she otherwise qualifies, Lila may exclude the $25,000 of COD income and 121 to exclude the gain. Here is the computation: Recourse debt $300,000 FMV ( 275,000) COD income $ 25,000 FMV $275,000 Basis ($250,000 minus $25,000 excluded under IRC 108(h)) (225,000) Gain $ 50,000 Sue has $25,000 COD income that is excludable under IRC 108(h) and $50,000 of gain that is excludable under IRC 121. Example of foreclosure on nonrecourse debt on a principal residence In the example above, Lila s debt is nonrecourse. Nonrecourse debt $300,000 Basis (250,000) Gain $ 50,000 There is no COD income on this foreclosure. As there is no COD income on this foreclosure, the foreclosure does not qualify for an exclusion under IRC 108. However, if she otherwise qualifies, she may still exclude the gain under IRC 121. THE QUALIFIED PRINCIPAL RESIDENCE EXCLUSION Using the principal residence exclusion, a taxpayer may exclude from income up to $2 million of COD income from the discharge of qualified principal residence indebtedness on or after January 1, 2007, and before January 1, (IRC 108(a)(1)(E) and IRC 108(h)) Qualified principal residence indebtedness is acquisition indebtedness as defined in IRC 163(h)(3)(B), but with a $2 million limit ($1 million for married filing separately). (IRC 108(a)(1)(E) and IRC 108(h)) It does not include home equity indebtedness for which mortgage interest may be allowable as a deduction under IRC 163(h)(3)(C). Principal residence has the same meaning as under the home sale exclusion rules of IRC 121. Spidell Publishing, Inc

13 Practice Pointer Qualified principal residence indebtedness as defined under IRC 108(h)(2) is the same as acquisition indebtedness as defined under IRC 163(h)(3)(B) with two important differences: Qualified principal residence indebtedness is limited to $2 million or $1 million on a separate return, whereas acquisition indebtedness for purposes of the mortgage interest deduction is limited to $1 million or $500,000 on a separate return; and Qualified principal residence indebtedness applies solely to a taxpayer s principal residence, and not a second home. For purposes of the mortgage interest deduction, acquisition indebtedness can be incurred with respect to a taxpayer s principal residence plus one other residence, such as a vacation home. The basis of a taxpayer s principal residence is reduced by the excluded COD income, but not reduced below zero. (IRC 108(h)(1)) Example of qualified principal residence indebtedness Tony and Tina purchased a home for $1.6 million. The original acquisition mortgage on the home was $1.5 million. Even though only $1 million qualifies as acquisition indebtedness for purposes of the home mortgage interest deduction under IRC 163(h)(3)(B), the entire $1.5 million qualifies as qualified principal residence indebtedness under IRC 108(h)(2). Example of home equity indebtedness When the value of the home is $1.8 million, Tony and Tina take out a second on the home of $100,000 to pay off credit cards. Although interest on the second is deductible for regular tax purposes (but not for AMT purposes), it is not qualified principal residence indebtedness for purposes of IRC 108(h)(2), and COD income attributable to this second may not be excluded as principal residence debt. WHEN A PORTION OF THE MORTGAGE IS NOT QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS As mentioned above, only COD income attributable to acquisition indebtedness may be excluded under the principal residence exclusion. What happens when only a portion of the debt (such as the amount that exceeds the $2 million statutory limit), or a separate debt (such as a home equity debt or a refinance loan whose proceeds weren t used for qualified purposes) is canceled along with acquisition indebtedness? Section 108(h)(4) provides for an ordering rule. Under this ordering rule, if only a portion of a discharged indebtedness is qualified principal residence indebtedness, the exclusion applies only to so much of the amount discharged that exceeds the portion of the debt that is not qualified principal residence indebtedness. (IRC 108(h)(4)) Effectively, then, the portion that is not qualified principal residence indebtedness is treated under IRC 108 as having been discharged first Spidell Publishing, Inc.

14 Example of nonexcludable debt Because they could not make their mortgage payments, both banks foreclosed on Tony and Tina s home when the FMV was $1.3 million. Under the ordering rule, the second on the home is treated as discharged first. Since it is not qualified principal residence indebtedness, it cannot be excluded under the principal residence exclusion. Example of nonexcludable debt Mr. and Mrs. Casey purchased a personal residence for $470,000, paying $40,000 down and obtaining a nonrecourse mortgage loan of $430,000. When the FMV of the residence had risen to $550,000, and the principal balance of the original mortgage loan was $420,000, they refinanced the first mortgage loan for $430,000 and took out a home equity line-of-credit from the same lender for $70,000. Both loans were recourse. The Caseys used the proceeds of the loans to purchase a boat. When the FMV of the residence was $380,000, the lender foreclosed on the property and canceled the remaining debts. At that time, the principal amounts owed on the two loans were $425,000 and $65,000. $5,000 of the $425,000 balance owed on the refinance loan does not qualify as principal residence indebtedness because IRC 163(h)(3)(B) provides that refinancing indebtedness ($425,000) qualifies as acquisition indebtedness, but only to the extent that it doesn t exceed the principal balance of the debt paid off by the refinance loan ($420,000). Also, none of the $65,000 balance owed on the HELOC loan qualifies as acquisition indebtedness since the proceeds were used to purchase a boat. The Casey s COD income is calculated as follows: Recourse debt ($425,000 + $65,000) $490,000 FMV (380,000) COD income $110,000 Less: Nonqualified debt ( 70,000) COD income eligible for principal residence exclusion $ 40,000 The Caseys will only be able to exclude $40,000 of this COD income under the principal residence exclusion. The Caseys will have to pay tax on the $70,000 of COD income that is not eligible for the exclusion. COORDINATION WITH OTHER PROVISIONS The exclusion does not apply to a taxpayer whose debt is discharged in a Title 11 bankruptcy case; instead the present-law bankruptcy exclusion of IRC 108(a)(1)(A) applies. (IRC 108(a)(2)(A)) Spidell Publishing, Inc

15 In the case of an insolvent taxpayer not in bankruptcy, the principal residence exclusion applies unless the taxpayer elects to have the present-law insolvency exclusion of IRC 108(a)(1)(B) apply. (IRC 108(a)(2)C)) For further discussion of the election to use the insolvency provisions, see below. CALIFORNIA S DEBT RELIEF PROVISIONS For taxable years beginning on or after January 1, 2009, California conforms to IRC 108(a)(1)(E) and 108(h)(2) with these major exceptions: Qualified principal residence indebtedness is limited to $800,000 ($400,000 for married filing a separate return) instead of the federal $2 million ($1 million for married filing a separate return); and The maximum cancellation of debt income (COD) exclusion is further limited to $500,000 ($250,000 for taxpayers married filing separately). (R&TC ) Example of lower COD exclusion for California Barney owns a home with recourse debt of $1,000,000; only $900,000 is qualified principal residence indebtedness. The FMV at the time of foreclosure is $700,000, and Barney s basis in the property is $900,000. For 2009, here is what Barney s federal and California COD would be: Federal Computation Step 1: Computing nonqualified principal residence indebtedness a. Total recourse debt $1,000,000 b. Subtract the lesser of qualified principal residence (900,000) indebtedness; or $2,000,000 c. Nonqualified debt 100,000 Step 2: Computing COD income a. Total recourse debt (from Step 1a) $1,000,000 b. Less FMV (700,000) c. COD income 300,000 d. Less nonqualified debt (from Step 1c) (100,000) e. Excludable COD $200,000 f. Taxable COD (2c minus 2e) $100,000 California Computation Step 1: Computing nonqualified principal residence indebtedness a. Total recourse debt $1,000,000 b. Subtract the lesser of qualified principal residence (800,000) indebtedness; or $800,000 c. Nonqualified debt $200,000 Step 2: Computing COD income a. Total recourse debt (from Step 1a) $1,000,000 b. Less FMV (700,000) c. COD income 300,000 d. Less nonqualified debt (from Step 1c) (200,000) e. Excludable COD (lesser of 2c - 2d, or $250,000) $100,000 f. Taxable COD (2c minus 2e) $200, Spidell Publishing, Inc.

16 Example of excess debt Randy purchased a home for $1.3 million. When the bank foreclosed on his home, the balance of his qualified principal residence indebtedness was $1 million and the fair market value was $750,000, resulting in COD income of $250,000 ($1 million minus $750,000). The debt was recourse. For federal purposes, the $250,000 COD is excludable from income. For California purposes, he must report $200,000 of COD income: Loan amount $1,000,000 Maximum QPRI (800,000) Taxable COD for CA $200,000 For California, his excludable COD is $50,000: COD $250,000 Excess of maximum QPRI $200,000 COD exclusion $50,000 Unless he qualifies for insolvency, he owes California tax on $50,000. Example of excess COD Bill purchased a residence for $800,000 and financed the entire amount with a recourse loan. Bill negotiated a short sale with the bank when the FMV was $250,000. For federal purposes, the $550,000 is excludable. For California purposes, he may not exclude more than $500,000. Thus, he owes tax on the $50, and 2008 provisions For 2007 and 2008 returns, the California differences were: Qualified principal residence indebtedness was limited to $800,000 ($400,000 for married filing a separate return) instead of federal $2 million ($1 million for married filing a separate return); California had a maximum COD income exclusion of $250,000 ($125,000 for married filing separately), while federal law does not have a maximum; and Like federal law, when excluding COD under the principal residence exclusion, the basis of the taxpayer s principal residence is reduced by any excluded COD income, but not below zero. (R&TC ) OTHER COD PROVISIONS California conforms to the other federal COD provisions found in IRC 108, including: Bankruptcy; Insolvency; and Business real property indebtedness. Spidell Publishing, Inc

17 EXCLUSION FROM INCOME IRC 108 Income from forgiveness of debt is taxable under IRC 61. However, IRC 108 contains provisions that allow a taxpayer to exclude COD income in certain cases, for example: A discharge of a debtor in a bankruptcy proceeding; A discharge of an insolvent taxpayer; A discharge of qualified farm indebtedness; A qualified student loan discharge; Discharge of debt in exchange for services; Qualified real property business indebtedness; or Deferral of income arising from reacquisition of business indebtedness (see above). (IRC 108(i)) In order of precedence, the bankruptcy exclusion comes first, followed by the insolvency exclusion. (IRC 108(a)(2)(A)) However, the 108(h)(1) exclusion for qualified principal residence indebtedness takes precedence over the insolvency exclusion, unless the taxpayer elects to apply the insolvency exclusion. The exclusion regarding bankruptcies takes precedence over all other provisions of 108 including the principal residence exclusion. Examples of ordering rules Dave, who is insolvent, loses his personal residence to a foreclosure, which results in COD income. He otherwise qualifies for the personal residence exclusion. Dave will utilize the principal residence exclusion unless he elects to use the insolvency provisions. Jeanne has COD income when part of the debt on her personal residence is discharged in a bankruptcy proceeding. She cannot use the principal residence exclusion; she must use the bankruptcy exclusion. THE BANKRUPTCY EXCLUSION No amount is included in a taxpayer s gross income by reason of a discharge of indebtedness (in whole or in part) in a bankruptcy proceeding. Specific tax attributes of the bankrupt taxpayer must be reduced by the amount excluded from income under the bankruptcy provisions, unless the taxpayer elects to apply all or any portion of the excluded amount first to reduce his basis in depreciable assets (discussed later). The bankruptcy exclusion applies even if the taxpayer is solvent after the discharge. Any amount of discharge of indebtedness that exceeds the amount by which tax attributes are reduced under this rule is disregarded. The excess is not included in income and has no other tax consequences. California fully conforms to this provision. THE INSOLVENCY EXCLUSION A taxpayer may exclude from income a discharge of indebtedness that occurs while the taxpayer is insolvent (but not involved in bankruptcy proceedings) up to the amount by which he or she is insolvent. (IRC 108(a)(1)(B), (a)(2)(a), and (a)(3)) Spidell Publishing, Inc.

18 The excluded amount is applied to reduce tax attributes in the same manner as if the discharge had occurred in a bankruptcy proceeding. And, as with the bankruptcy exclusions, an insolvent taxpayer may elect to apply all or a portion of the excluded amount first to reduce his basis in depreciable assets or in real property held as inventory, rather than to reduce the tax attributes. The amount of any discharge of indebtedness in excess of the amount by which the taxpayer is insolvent is treated in the same manner as the discharge of the indebtedness of a wholly solvent taxpayer, and thus, will generally be included in income. (IRC 61(a)(12), 108(a)(3)) When is a taxpayer insolvent? The term insolvent means that there is an excess of liabilities over the FMV of assets, determined on the basis of the taxpayer s assets and liabilities immediately before the discharge. (IRC 108(d)(3)) Assets for this purpose include assets that are exempt from creditors claims under state law. (Carlson v. Comm. (2001) 116 TC 87) Liabilities include contingent liabilities or liabilities that the taxpayer has guaranteed if it is more likely than not that the taxpayer will be called upon to pay them. (Merkel v. Comm., 192 F.2d 844 (9th Cir. 1999)) A taxpayer must be able to prove insolvency. (Rinehart v. Comm., TCM ) For many taxpayers, especially those who have frequently refinanced their residence, the insolvency provisions will allow them to exclude most of their discharge. Example of insolvency Gary bought his house for $200,000. He refinanced the property several times, and used the proceeds to send his kids to college, take vacations, purchase a boat, etc. The value of the house had risen to $700,000, and the balance of his mortgage was $650,000. All of the debt was recourse debt, and only $150,000 was acquisition indebtedness. The home s value has fallen to $500,000. He has other assets worth $50,000 and other liabilities of $80,000. Gary is insolvent to the extent of $180,000 (total assets = $550,000; total liabilities = $730,000). Assets for purposes of the insolvency exclusion For purposes of the insolvency exclusion, the term insolvent means the excess of liabilities over the FMV of assets. Insolvency is determined on the basis of the taxpayer s assets and liabilities immediately before the discharge. The Code provides only for assets. Thus, a taxpayer must count cash, stocks and bonds, and other business and investment assets along with personal assets such as a personal residence, auto, and household goods. More controversial are exempt assets. Both the IRS and the Tax Court have previously held that assets exempt from creditors claims are excluded when taking account of a taxpayer s assets in determining insolvency. (Babin v. Comm., TCM ; Hunt v. Comm., TCM ; Estate of Marcus v. Comm., TCM , PLR ) However, these cases were decided under the judicial insolvency exclusion that preceded the statutory exclusion. Spidell Publishing, Inc

19 More recently, both the Tax Court and the IRS have ruled the opposite way; that is, that assets exempt from creditors are counted, (Carlson v. Comm., 116 TC 87 (2001), PLR , TAM ) including pension assets. (SCA ) For purposes of valuing pension assets, defined contribution plans are valued as the FMV of the participant s account on the date of discharge. Defined benefit plans are valued in one of two ways based on whether or not the participant has started receiving benefits: Has started to receive benefits: Actuarial present value of the payments to be made using the interest rate and mortality tables at Treas. Regs ; or Has not started receiving benefits: Greater of the actuarial present value of the accrued benefit payable at normal retirement age, or the amount of any single-sum distribution that the participant could receive under the plan as of the discharge date Spidell Publishing, Inc.

20 Spidell Publishing, Inc

21 Nonrecourse debt and insolvency For purposes of computing a taxpayer s insolvency, excess nonrecourse debt ( excess meaning the amount by which the debt exceeds the property s FMV) is not counted as a liability in determining insolvency except to the extent that the excess nonrecourse debt is discharged. (Rev. Rul , C.B. 48) Here s the reasoning for this treatment of nonrecourse debt. The insolvency provisions exist because, as a matter of public policy, an insolvent taxpayer should not be burdened with current taxation on a discharge to preserve the taxpayer s fresh start resulting from the discharge; that is, the fresh start should not be impeded by imposing a tax liability on the taxpayer when the taxpayer is unable to pay either the indebtedness or the tax. Excess nonrecourse debt is not taken into consideration in computing insolvency, except when discharged, because it has no effect on a taxpayer s ability to pay tax; that is, because the lender will never be able to recover any more than the FMV of the property. Example of nonrecourse debt on insolvency Variation 1: Assume, in the above example, that Gary s $650,000 mortgage loan was nonrecourse. Now assume that he reached an agreement with his other creditors to settle the $80,000 in liabilities for $20,000. As a result, he has COD income of $60,000. Immediately before the discharge, Gary is insolvent to the extent of only $30,000 (other assets of $50,000 less other liabilities of $80,000; the excess nonrecourse debt is not included in the computation). As such, he can exclude only $30,000 of the $60,000 of COD income. Variation 2: Assume, again, that the $650,000 mortgage loan is nonrecourse, but instead, that the lender agreed to reduce his mortgage loan to the FMV of the property, $500,000. As such, $150,000 is discharged. Now, Gary is insolvent to the extent of $180,000 which is: $30,000 the excess of other liabilities over other assets, plus $150,000 the lesser of the amount of nonrecourse debt discharged ($150,000) or the amount of excess nonrecourse debt (also $150,000). In this situation, Gary can exclude the entire $150,000 of discharge. The IRS has ruled that the insolvency exclusion is not available to a taxpayer who transfers property to the lender in exchange for the cancellation of the nonrecourse debt to which the property is subject, because cancellation is included in taxpayer s amount realized in the sale of the property and is not cancellation of indebtedness income. (Rev. Rul , C.B. 12; TAM ) INSOLVENCY AND RESIDENCE EXCLUSION Electing the insolvency provisions over residence exclusion As previously noted, a taxpayer who qualifies under the principal residence exclusion may elect to use the insolvency provisions if the taxpayer is insolvent. For most taxpayers, the residence exclusion would be preferable because any reduction of basis would, in turn, Spidell Publishing, Inc.

22 result in gain that would be excludable under IRC 121. Taxpayers who might choose the insolvency provisions include: Taxpayers whose discharge amount exceeds the $2 million limit for a principal residence; Taxpayers who have nonqualified debt that is forgiven; Taxpayers who will have gain in excess of their allowable 121 exclusion; Taxpayers who have tax attributes that are in excess of any they can ever expect to use, including those whose carryover attributes may soon expire; and Since California only partially conforms to the principal residence exclusion, an insolvent taxpayer may use the residence exclusion for federal purposes and the insolvency exclusion for California purposes. Example of electing insolvency exclusion John s house has a FMV of $500,000 and a basis of $225,000. It is encumbered by recourse debt of $700,000. He is insolvent to the extent of $200,000. He has a net operating loss (NOL) carryover of $300,000. Computation using the principal residence exclusion If he otherwise qualifies, John may exclude the $200,000 of COD income and 121 to exclude the gain. Here is the computation. Recourse debt $700,000 FMV (500,000) COD income $200,000 Less: COD income excluded (200,000) Recognized COD income $ 0 FMV $500,000 Basis ($225,000 minus $200,000 excluded under IRC 108(h)) (25,000) Gain $475, exclusion (250,000) Recognized gain $225,000 Computation under insolvency Recourse debt $700,000 FMV (500,000) COD income $200,000 Less: COD income excluded under insolvency (200,000) Recognized COD income $ 0 FMV $500,000 Basis (225,000) Gain $275, exclusion (250,000) Recognized gain $25,000 John must reduce his $300,000 NOL carryover by $200,000, the amount of COD excluded. His NOL carryover is reduced to $100,000. Spidell Publishing, Inc

23 Using both the residence and the insolvency exclusions Except where debt is discharged in a bankruptcy proceeding, IRC 108 does not require a taxpayer to use only one exclusion if more than one exclusion applies. An example is the situation where the taxpayer can exclude part of the COD income under the personal residence exclusion and the balance under the insolvency exclusion. The Code states that the principal residence exclusion takes precedence over the insolvency exclusion. But how this works precisely is that unless the taxpayer elects to use the insolvency exclusion as explained above, the principal residence exclusion must be used first to exclude any COD income attributable to qualified principal residence debt, and then the taxpayer may use the insolvency exclusion for any remaining COD income. (IRC 108(a)(2)(C)) California conforms to the insolvency provision. A taxpayer may make a different election to use insolvency rather than the principal residence exclusion on the California return. Example of using principal residence and insolvency exclusions Mr. and Mrs. Drake purchased a personal residence for $3,000,000, paying $700,000 down and obtaining a nonrecourse mortgage loan of $2,300,000. In 2006, they refinanced the mortgage for $2,400,000, which was a recourse loan. By November 2009, the FMV of the residence had fallen to $1,600,000; they owed $2,300,000 on the mortgage, and were in default. In December 2009, the lender foreclosed, sold the residence to a third party for its FMV of $1,600,000, and canceled the remaining $700,000 debt owed by the Drakes. The lender sent the Drakes a Form 1099-C showing income from cancellation of indebtedness of $700,000. Just before the lender had canceled the debt, the Drakes were insolvent to the extent of $683,000: Remaining loan balance $700,000 Credit card debt 15,000 Total liabilities before debt cancellation $715,000 Savings account $ 5,000 FMV Car ($16,000 basis) 10,000 FMV Retirement account ($2,000 basis) 17,000 FMV of assets before debt cancellation $32,000 Extent of insolvency ($715,000 - $32,000) $683,000 As a result of the debt cancellation, the Drakes have COD income of $700,000: Recourse debt $2,300,000 FMV (1,600,000) COD income $ 700,000 The maximum amount that the Drakes can treat as qualified principal residence debt under IRC 108(h) is the statutory maximum of $2,000,000, but the principal amount of their loan before the debt cancellation was $2,300,000, so $300,000 is not eligible for the principal residence exclusion Spidell Publishing, Inc.

24 Example of using insolvency and residence exclusion The ordering rule of IRC 108(h)(4) essentially treats the nonqualified debt for purposes of IRC 108 as having been discharged first. As a result, the Drakes can exclude only $400,000 of the $700,000 COD income under the principal residence exclusion. This still leaves $300,000 of COD income. However, the Drakes were insolvent before the debt was canceled, so they also qualify for the insolvency exclusion of IRC 108(a)(1)(B). The extent of their insolvency was $683,000, which is more than enough to absorb the remaining $300,000 of COD income. Accordingly, the Drakes will exclude $400,000 of COD income under the principal residence exclusion, and $300,000 under the insolvency exclusion, so that none of the COD income is taxable on their federal return. Under IRC 108(h)(1), the Drakes must reduce the basis of their residence by the $400,000 of COD income that was excluded from gross income under the principal residence exclusion. As a result, they will have a $1,000,000 personal, non-deductible loss on the transaction: FMV $1,600,000 Basis ($3,000,000 less $400,000 exclusion) (2,600,000) Loss (nondeductible) ($1,000,000) Since the Drakes also excluded $300,000 of COD income under the insolvency exclusion, IRC 1017 requires them to reduce the basis of other property held at the beginning of the year following the year in which the debt was canceled. Since the only property (other than cash) that they owned at the beginning of 2009 was the car ($16,000 basis) and the retirement account ($2,000 basis), the Drakes will reduce the basis of these two assets to zero. For California purposes, the Drakes would not be able to exclude any of the COD income under the California mortgage relief provision in California law limited the amount of qualified principal residence debt to $800,000. Accordingly, only $800,000 of the $2,300,000 debt qualifies for the exclusion, and $1,500,000 of the debt does not. The nonqualified debt must be treated under IRC 108(h)(4) as having been discharged first, leaving none of the COD income as qualifying for the California exclusion. However, California follows federal law regarding the insolvency exclusion. Since the Drakes may not exclude any COD income under the California principal residence exclusion, they will instead use the insolvency exclusion to exclude as much of the COD income as possible on their California return. Since the extent of their insolvency is $683,000, they may exclude this amount of COD income under the insolvency exclusion, leaving $17,000 of the COD income as taxable. For California purposes, the Drakes will similarly reduce the basis of the car ($16,000 basis) and the retirement account ($2,000 basis) to zero at the beginning of They will still have a nondeductible loss on the disposition of their residence: FMV $1,600,000 Basis (3,000,000) Loss (nondeductible) ($1,400,000) Spidell Publishing, Inc

25 THE QUALIFIED FARM INDEBTEDNESS EXCLUSION A discharge of qualified farm indebtedness does not result in discharge of indebtedness income. (IRC 108(a)(1)(C)) This exclusion does not apply, however, to the extent that the insolvency or bankruptcy exclusions apply. (IRC 108(a)(2)(A) and (B)) Qualified farm indebtedness is indebtedness incurred directly in connection with the taxpayer s operation of the trade or business of farming, but only if 50% or more of the taxpayer s aggregate gross receipts for the three taxable years prior to the taxable year in which the discharge of indebtedness occurs is attributable to the trade or business of farming. (IRC 108(g)(2)) The debt must be discharged by a qualified person, which means anyone who is actively and regularly engaged in the business of lending money, and who is not related to the taxpayer, is not a person from whom the taxpayer acquired the property (or a person related to such person), and is not a person who receives a fee from the taxpayer s investment in the property (or a person related to such person). A qualified person includes any governmental agency. (IRC 108(g)(1)) California conforms to the farm exclusion. THE EXCLUSION FOR CANCELLATION OF STUDENT LOANS The discharge of student loans does not give rise to discharge of indebtedness income if the discharge is pursuant to a provision in the loan agreement under which all or a part of the student loan is forgiven, so long as the student works for a certain period of time in certain professions for any of a broad class of employers. In addition, an individual s gross income does not include forgiveness of loans made by tax-exempt charitable organizations (e.g., educational organizations or private foundations) if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance outstanding student loans and the student is not employed by the lender organization. (IRC 108(f)(3)) This provision applies to a law school s loan repayment assistance program that forgives all or part of a student s debt if the graduate completes a period of employment in lawrelated public service position. (Rev. Ruls , I.R.B. 76) California conforms to the exclusion for student loan forgiveness. LOAN REPAYMENT PROGRAMS Loan repayment programs, where a third party (usually a government agency) makes payments on a participant s student loans in return for public service, result in income to the debtor. These programs don t qualify for the student loan forgiveness exception because the loans aren t discharged but are repaid by a third party. However, under a separate exception, an individual s gross income doesn t include amounts received under a state program described in 338I of the Public Health Service Act, which provides federal grants to states for their loan repayment programs. Similarly, an individual s gross income doesn t include amounts received under the National Health Service Corps Loan Repayment Program ( 338B(g) of the Public Health Service Act), which provides student loan Spidell Publishing, Inc.

26 repayments to participants who provide medical services in a geographic area that the Public Health Service identifies as having a shortage of health-care professionals. For amounts received by an individual in tax years beginning on or after January 1, 2009, the gross income exclusion is modified to include any amount received by an individual under any state loan repayment or loan forgiveness program that is intended to provide for the increased availability of health care services in underserved or health professional shortage areas (as determined by the state). (IRC 108(f)(4), as amended by Health Care Act 10908) THE EXCLUSION FOR DISCHARGE OF QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS While the IRC 108 and IRC 121 provide potential exclusions on a principal residence for solvent taxpayers, IRC 108 also provides a potential exclusion for another class of solvent taxpayers owners of qualified business real property. Taxpayers (other than C corporations) may elect to exclude from gross income certain income from discharge of qualified real property business indebtedness. The amount so excluded is treated as a reduction in the taxpayer s basis of certain depreciable real property and cannot exceed the basis of that property. (IRC 108(c)) Note: As previously observed, the bankruptcy exclusion and the insolvency exclusion both take precedence over the qualified business real property exclusion. Qualified real property business indebtedness must meet three requirements: It was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property; It was incurred or assumed before January 1, 1993, or if incurred or assumed on or after such date, is qualified acquisition indebtedness; and The taxpayer elects to exclude COD income with respect to such indebtedness. (IRC 108(c)(3)) Qualified acquisition indebtedness (the second requirement) is debt that is incurred or assumed to acquire, construct, or substantially improve real property used in a trade or business. (IRC 108(c)(4)) Refinancing indebtedness also qualifies, but only to the extent that it doesn t exceed the refinanced indebtedness (the principal balance of the debt paid off by the refinance loan). However, to the extent that the proceeds from the refinance loan are used to substantially improve the property, that portion will qualify. But if the proceeds from the refinance loan are not used to substantially improve the property, that portion won t be eligible for the exclusion. The election is made on Form 982 on the tax return for the year in which the cancellation occurs. It must be filed by the due date of the return, including extensions. (Treas. Regs (b)) However, if you timely filed your return for the year without making the election, you can still make the election by filing an amended return within six months of the due date of the return, excluding extensions. (See instructions to Form 982, citing Treas. Regs ) DOES RENTAL PROPERTY QUALIFY FOR THE EXCLUSION? To qualify for the exclusion, the debt must be incurred in connection with real property used in a business. Historically, the courts have held that the rental of even a single property may constitute a business under various provisions of the Code. (See, e.g., Curphey v. Spidell Publishing, Inc

27 Comm., 73 TC 766, 773 (1980); Hazard v. Comm., 7 TC 372 (1946, Acq C.B. 3); Post v. Comm., 26 TC 1055 (1956, Acq C.B. 7); Gilford v. Comm., 201 F.2d 735 (2d Cir. 1953); Schwarcz v. Comm., 24 TC 733 (1955, Acq C.B. 5); Elek v. Comm., 30 TC 731 (1958, Acq., C.B. 5 ); Fegan v. Comm., 71 TC 791 (1979), aff d USTC (CCH) 9436 (10th Cir. 1981); Pinchot v. Comm., 113 F.2d 718 (2d Cir. 1940).) But this is not always true, such as where the taxpayer is essentially an investor or the lease is a net lease (Neili, 46 B.T.A. 197 (1942); Rev. Rul , C.B. 226) The issue is ultimately one of fact in which the scope of a taxpayer s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business. (Bauer v. United States, 168 F. Supp. 539, 541 (Ct. Cl. 1958); Schwarcz v. Commissioner, 24 TC 733 (1955)) In TAM , the IRS announced that it was taking the position that the mere rental of real property does not constitute a trade or business under IRC As a result, taxpayers may be concerned about whether the IRS will allow the IRC 108(c) exclusion for rental property since the language of IRC 108(c)(3)(A) is nearly identical to IRC The IRS allowed the exclusion for a multi-tenant office building held by a limited partnership and for a multi-unit residential building held by a general partnership (PLRs and ), but what about renting a single family residence? Ultimately, the issue depends upon the facts and circumstances. If the taxpayer rents the residence continuously to an unrelated party for a fair market rent, then it will probably be considered a business (see Mayes v. United States, 60 AFTR2d (RIA) 5046, 87-2 USTC (CCH) 9478 (W.D.Mo. 1986)). The IRS hinted at this in CCA LIMITATIONS ON EXCLUSION The amount excluded under this provision generally cannot exceed the lesser of: The amount by which the principal amount of the debt that is discharged exceeds the FMV of the property securing the debt; or The taxpayer s basis in depreciable real property. (IRC 108(c)(2)) The taxpayer must reduce the basis of the depreciable real property by the excluded amount, at the beginning of the taxable year following the taxable year in which the discharge occurs. FMV limitation Under the FMV limitation, the debt discharge income that can be excluded may not exceed the excess of the outstanding principal amount of debt (immediately before the discharge) over the FMV (immediately before the discharge) of the business real property that secures the qualified real property business indebtedness, reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by the property (immediately before the discharge) Spidell Publishing, Inc.

28 Example of exclusion limitations Ashley (who is neither bankrupt nor insolvent) owns a building with a FMV of $500,000 that she uses in a trade or business. The balance of the first mortgage is $350,000, and the balance of the second is $200,000. Both loans are qualified real property business indebtedness. The holder of Ashley s second mortgage agrees to reduce the debt from $200,000 to $125,000, resulting in COD income of $75,000. Assuming that Ashley has sufficient depreciable basis in qualifying business real property to absorb the reduction, she can exclude $50,000 of that discharge from gross income. Her exclusion is limited to $50,000 because that is the amount by which the balance of the debt (immediately before the discharge) exceeded the FMV of the property (immediately before the discharge). The remaining $25,000 of discharge is included in her gross income. Depreciable basis limitation Under the depreciable basis limitation, the amount of debt discharge income that can be excluded may not exceed the aggregate adjusted basis of depreciable real property held by the taxpayer immediately before the discharge. (IRC 108(c)(2)(B)) This aggregate basis limitation must be determined after any basis reductions occurring as a result of the application of the other IRC 108 exclusions for bankruptcy, insolvency, or qualified farm indebtedness. APPLYING THE BASIS REDUCTION The discharge of indebtedness income excluded under IRC 108(c) must be applied as a basis reduction to depreciable real property held by the taxpayer using the rules of IRC The reduction is applied as of the beginning of the taxable year following the taxable year in which the discharge occurs. (IRC 108(c)(1), 1017(a)(2), 1017(b)(3)) However, if the taxpayer disposes of depreciable real property before the first day of the next taxable year, the reduction in basis of such property is made as of the time immediately before its disposition. (IRC 1017(b)(3)(F)(iii)) The recapture rules apply to the basis reduction upon the disposition of depreciable real property. (IRC 1017(d)) In applying the IRC 1250 recapture rules, the IRC 1017 basis reduction is treated as a depreciation deduction, and the computation of straight line depreciation is made as if there had been no 1017 reduction. As such, the recapture amount is reduced over time, as the taxpayer forgoes depreciation deductions because of the basis reduction. Spidell Publishing, Inc

29 Example of basis reduction In January 2008, Mr. and Mrs. Franklin purchased residential rental property for $355,000, paying $55,000 down and obtaining a $300,000 interest-only recourse loan. During the latter portion of 2008, the Franklins stopped making loan payments. The Franklins deducted $5,000 in depreciation on their 2008 return. In January 2009, when the FMV of the property was $200,000, the lender foreclosed and canceled the $300,000 debt. The Franklin s adjusted basis in the property was $350,000 ($355,000 cost minus $5,000 depreciation). The Franklins were not insolvent at the time that the debt was canceled, and they didn t own any other depreciable real property. As a result of the debt cancellation, the Franklins had $100,000 of COD income ($300,000 recourse debt minus $200,000 FMV). Assuming that they make the qualified real property business indebtedness election to exclude this income by filing Form 982 with their 2009 return, they will qualify to exclude all of the COD income for both federal and California income tax purposes. The Franklins will have a $50,000 loss on the foreclosure, computed as follows: FMV of rental property $200,000 Less: Cost basis $355, depreciation (5,000) IRC 108 exclusion (100,000) Adjusted basis $250,000 (250,000) Loss on foreclosure ($50,000) The loss on the foreclosure will be deductible as an ordinary loss on Form 4797 under IRC SPECIAL RULES FOR PARTNERSHIPS AND S CORPORATIONS When a discharge of qualified business real property debt occurs with respect to property held by a partnership, the determination of whether debt is qualified real property indebtedness and the application of the FMV limitation is made at the partnership level. (H. Rep. No , 103d Cong., 1 st Sess (1993)) Accordingly, where a debt of a partnership is canceled, the question of whether the debt was incurred in connection with real property used in a business is made with reference to the business of the partnership. However, the election to exclude discharged qualified real property business indebtedness from income is made at the partner level on a partner-by-partner basis. (IRC 108(d)(6), 703(b)(1)) As such, the aggregate depreciable basis limitation should be determined at the partner level. A partner s interest in a partnership that owns depreciable real property is treated as depreciable real property itself to the extent of the partner s proportionate interest in the depreciable real property held by the partnership. (Robinson, Federal Income Taxation of Real Estate (6th Ed. 2008), 9.06[4][c]) The partnership s basis in depreciable real property must correspondingly be reduced. This brings up the tricky question of the taxpayer utilizing the partnership s assets as well as the assets of other partnership interests held by the taxpayer for purposes of meeting the basis limitations. The tricky nature of this question is compounded by the possibility that some partners may elect and others may not Spidell Publishing, Inc.

30 These questions, the adjustments to partnership assets, and the amount of income distributed or required to be distributed if an election is made are beyond the scope of this discussion. However, in brief: A partner may request that a partnership reduce the inside basis of its depreciable property, and the partnership may grant or withhold such consent; (Treas. Regs (g)(2)(ii)) The regulations prescribe certain rules regarding when a partnership may or must consent to the request based on the percentage ownership of the partners making the request; If consent is granted, the basis of partnership assets is adjusted with respect to the electing partners only; and The adjustment to basis is treated similarly to an adjustment under IRC 743(b). In the case of a solvent S corporation, the exclusion is much simpler. The election is made by the S corporation and the exclusion and basis reduction are both made at the S corporation level. (IRC 108(d)(7), 1363(c)) There is no adjustment to the basis of the shareholder s stock for the amount of debt discharge income that is excluded at the corporate level. As a result of the basis adjustment, the corporation will have smaller depreciation deductions and, at the time of sale of the subject asset, a larger gain or smaller loss. The effect of the election, then, is to defer income. PROPERTY CONVERTED FROM PERSONAL TO BUSINESS USE, OR VICE VERSA If a taxpayer s principal residence is subsequently converted to rental use, or vice versa, and there is COD income from a foreclosure or similar transaction, which exclusion under IRC 108 applies? The Qualified Principal Residence Indebtedness exclusion or the Qualified Real Property Business Indebtedness exclusion under IRC 108(a)(1)(D) and (c)? The statute states that the exclusion depends upon the indebtedness discharged. (IRC 108(a)(1)(D) and (E)) Accordingly, whether the taxpayer qualifies for the principal residence exclusion or the real property business exclusion depends upon the use of the property at the time that the debt is canceled. If the property is being used as the taxpayer s principal residence, then the principal residence exclusion applies. If the property has been converted to rental use, then the real property business exclusion applies. Taxpayers must be careful about abandoning property because they could potentially invalidate their eligibility for an exclusion when they do so. If, for example, a taxpayer abandons property used in a business, and six months later the lender forecloses on the property and cancels the debt, the IRS could argue that the taxpayer is not eligible for the real property business exclusion because the property was not being used in a trade or business at the time that the debt was canceled. A similar argument could be used concerning an abandoned personal residence. One strategy that has been recommended to clients who owe more on their personal residence than it s worth, who are facing a large tax bill due to debt that doesn t qualify for the exclusion (e.g., the debt exceeds the statutory $2 million limit), and who want to purchase a new personal residence before the lender forecloses and damages their credit, is to go ahead and purchase the new personal residence and convert the old residence into a rental. These clients may not be eligible for a full exclusion of COD income under the federal principal residence exclusion rules due to the nonqualified debt, and may not be entitled to any exclusion under California law. Converting the old residence into a rental and renting the property for a period of time until the lender forecloses makes them eligible for the real property business indebtedness exclusion, to which California law conforms. California conforms to this exclusion. You may not make a separate California election. Spidell Publishing, Inc

31 REVIEW QUESTIONS Under the NASBA-AICPA self-study standards, self-study sponsors are required to present review questions intermittently throughout each self-study course. Additionally, feedback must be given to the course participant in the form of answers to the review questions and the reason why answers are correct or incorrect. To obtain the maximum benefit from this course, we recommend that you complete each of the following questions, and then compare your answers with the solutions that immediately follow. These questions and related suggested solutions are not part of the final examination and will not be graded by the sponsor. 1. If a member of the military enters into a vehicle lease, and is later deployed for a period of not less than 180 days, he or she may terminate the lease but must recognize income. a) True b) False 2. Which of the following loans is nonrecourse under California law? a) A loan to purchase a principal residence b) A refinanced loan c) Both A and B d) Neither A nor B 3. Under IRC 121, a taxpayer can exclude up to $ of the gain ($ for married filing joint) on the sale of a house if the house is used as the taxpayer s primary residence for two of the past five years, among other requirements. a) 250,000; 500,000 b) 500,000; 1,000,000 c) 1,000,000; 2,000,000 d) None of the above 4. For California purposes, qualified principal residence indebtedness is limited to $ ($ for married filing a separate return). a) 500,000; 250,000 b) 800,000; 400,000 c) 2 million; 1 million d) 400,000; 200, IRC contains provisions that allow a taxpayer to exclude COD income in certain cases, such as discharge of debt in exchange for services. a) 61 b) 121 c) 108 d) Loan repayment programs, where a third party (usually a government agency) makes payments on a participant s student loans in return for public service, result in income to the debtor unless an exclusion applies. a) True b) False 2010 A Spidell Publishing, Inc.

32 DEFERRAL OF INCOME ON REPURCHASED DEBT (IRC 108(i)) Under the American Recovery & Reinvestment Act of 2009, a taxpayer may defer the recognition of debt discharge income on certain business debt discharged in 2009 or The income is recognized ratably over five years beginning in This elective provision applies to the reacquisition of an applicable debt instrument. Reacquisition A reacquisition means, for any applicable debt instrument, the acquisition of the debt instrument by the obligor or a related person or entity. It includes: An acquisition for cash; The exchange of the debt instrument for another debt instrument (including a modification of the original debt instrument); The exchange of the debt instrument for corporate stock or a partnership interest; The contribution of the debt instrument to capital; The complete forgiveness of the indebtedness by the holder of the debt instrument. (IRC 108(i)(4)) Debt instrument is broadly defined to include a bond, note, certificate, or any other instrument or contractual arrangement constituting indebtedness as defined under IRC 1275(a). Applicable debt instrument means any debt instrument that was: Issued by a C corporation; or Any person or entity in connection with the conduct of a trade or business. Example of reacquisition In 2010, ABC Corporation pays $7 million to reacquire notes it issued with an adjusted issue price of $10 million. ABC realizes $3 million of COD income. If it makes the 108(i) election, then it will recognize $600,000 of COD income in each of the five years, 2014 through Acceleration of deferred items In the case of a taxpayer s death, the liquidation or sale of substantially all of the taxpayer s assets, or the taxpayer s cessation of business, the income from the COD is accelerated into the taxpayer year in which the event occurs. (IRC 108(i)(5)(D)(i)) Passthrough entities Elections involving partnerships and S corporations are made at the entity level. (IRC 108(i)(6)) Spidell Publishing, Inc.

33 Reasons to pay tax now: Electing to report income now versus later The COD could be discharged based on insolvency (however, in most cases the bank will not adjust the note if the taxpayer is insolvent.) Low income, a current year loss, or an NOL may absorb the COD income The transaction is complete and no need to consider future tax issues Possible higher tax rates in the future may mean the cost is greater For an individual, if the taxpayer dies, the income could be accelerated into a high income year with no planning opportunities If business is liquidated, debt is included in final year and there is no control and possibly limited planning potential. Reasons to elect to pay later: Don t pay now what you can pay later Only 20% per year is added to income Time value of money If business fails, insolvency may result in discharge IRS PROVIDES GUIDANCE (REV. PROC ) The IRS states that a taxpayer makes the 108(i) election by attaching a statement meeting the requirements of Rev. Proc , 4.05 to its timely filed return (including extensions). The common parent of a consolidated group makes the election on behalf of all of its members. Generally, the required information includes identifying information for the issuer of the obligation, identifying information of the debt instruments, the reacquisition transactions, the COD income for each qualifying instrument, and the amount being deferred. Partial elections: An entity may elect to defer only part of the COD realized from the reacquisition of an applicable debt instrument. It may exclude from income the portion of COD the taxpayer doesn t elect to defer if it qualifies under any of the 108 exclusion provisions (insolvency, real property business indebtedness, etc.). Comment If the taxpayer elects to defer income, the taxpayer will eventually recognize the income. However, under the deferral election, the taxpayer does not have to reduce tax attributes as it does under the exclusion provisions. CALIFORNIA NONCONFORMITY Federal law allows an election to defer COD income in connection with the reacquisition of an applicable debt instrument occurring in 2009 and (IRC 108(i)) The deferred income is included in gross income ratably over a five-taxable-year period beginning: For reacquisitions occurring in 2009, the fifth taxable year following the taxable year in which a 2009 reacquisition occurred; and For reacquisitions occurring in 2010, the fourth taxable year following the taxable year in which a 2010 reacquisition occurred. California does not conform to this provision. Spidell Publishing, Inc

34 Example of federal deferral of COD In 2009, Pete renegotiates his business loan of $10 million for $6 million. He realizes $4 million of COD income. For federal purposes, he elects to defer the COD income under IRC 108(i). He will recognize $800,000 of the COD income ($4 million 5) each year from 2014 through For California purposes, Pete must report $4 million in COD income in the 2009 taxable year. Practice Pointer Track this difference. When the COD is reported in a future year, reduce the California income by the amount reported. In the previous example, Pete will have a California subtraction for each year that he reports the COD on his federal return. REDUCTION OF TAX ATTRIBUTES Where COD income is excluded under the principal residence provision of IRC 108(h)(1), the only reduction required in tax attributes is a reduction of the basis in the residence itself. This reduction in basis could create a capital gain if there is a disposition of the residence. However, in the case of an exclusion involving the bankruptcy, insolvency, or farm indebtedness provisions, specific tax attributes of the taxpayer must be reduced by the amount excluded from income, unless the taxpayer elects to apply all or any portion of the excluded amount first to reduce his basis in depreciable assets (or in real property held as inventory). (IRC 108(b)(5), 1017(b)(3)(A)) The taxpayer must reduce the following tax attributes in the following order: NOLs and carryovers; Carryovers of the general business credit; The minimum tax credit available under IRC 53(b); Capital losses and carryovers; The basis of assets (both depreciable and nondepreciable); Passive activity losses and carryovers; and Carryovers of the foreign tax credit. Generally, you reduce the attributes dollar for dollar by the amount of income excluded. However, you reduce credits (general business credits, minimum tax credits, or foreign tax credits) by 33⅓ cents for every dollar of income excluded. (IRC 108(b)(3)) Rather than reduce tax attributes, a taxpayer can elect to reduce basis in depreciable property, or in real property held primarily for sale to customers in the ordinary course of her trade or business. (IRC 108(b)(5), 1017(b)(3)(E)) Any remaining amount is then applied to reduce the other tax attributes in the order described above. The taxpayer may still exclude the income even if there are no tax attributes. California conforms to the reduction of tax attributes. However, for California purposes, the reduction of credit carryovers is 11.1 cents for every dollar of income excluded. (R&TC 17144(c), 24307(d)) If the taxpayer has more than one credit carryover, the credits are reduced pro rata. Also, because California tax attribute amounts will often be different, the amounts will be different. Note that California does not allow a separate election to reduce basis of depreciable property. (R&TC 17134, 17144, 24307) Spidell Publishing, Inc.

35 To see the difference, let s bring back Gary. Changes are in bold. Example of federal and California attribute difference Gary bought his house in 1991 for $200,000. He refinanced the property several times through 2006 and used the proceeds to send his kids to college, take vacations, purchase a boat, etc. In 2006, the value of the house had risen to $700,000 and the balance of his mortgage was $650,000. It was all nonrecourse debt and only $150,000 was acquisition indebtedness. By early 2009, the home s value had fallen to $500,000. He has other assets worth $50,000 and other liabilities of $80,000. Gary is insolvent to the extent of $180,000 (total assets = $550,000; total liabilities = $730,000). Now assume that he reached an agreement with his other creditors to settle the $80,000 in liabilities for $20,000. As a result, he has COD income of $60,000. Immediately before the discharge, Gary is insolvent to the extent of only $30,000 (other assets of $50,000 less other liabilities of $80,000; the excess nonrecourse debt is not included in the computation). So, he can exclude only $30,000 of the $60,000 of COD income. Gary must reduce tax attributes by the $30,000 discharged. Gary has a $20,000 NOL carryforward for federal purposes but only $5,000 for California. He has $40,000 capital loss carryforwards for both federal and California. He reduces both the federal and California NOL carryforwards to zero. He reduces his federal capital loss carryforward by $10,000 and his California by $25,000. He is left with a federal capital loss carryforward of $30,000 and a California capital loss carryforward of $15,000. COORDINATING THE 108 RELIEF PROVISIONS WITH EACH OTHER AND WITH IRC 121 As we ve seen, there are several provisions of the law that may provide relief on the foreclosure of real property. Each of these provisions applies to different types of income (COD income or gain), pertain to different types of property (e.g., principal residence, business property), have rules that require certain exclusions to take precedence over others, and require adjustments to different tax attributes. In some cases, the taxpayer has a choice as to which provision to utilize and which attribute adjustments to make. The following chart may make these choices easier to see. Spidell Publishing, Inc

36 COD or gain Property secured by Precedence Tax attributes Residence exclusion 108(h)(1) Bankruptcy 108(a)(1)(A) Insolvency 108(a)(1)(B) Business 108(a)(1)(D) 121 COD only COD only COD only COD only Gain only Principal residence only After bankruptcy but may elect insolvency Basis of principal residence only All debts Takes precedence In accordance with 108(b)(2) All debts After bankruptcy and principal residence exclusion In accordance with 108(b)(2) Business real property only After bankruptcy and insolvency Basis of business real property Principal residence only N/A N/A REPORTING THE COD On a discharge of debt, the lender is required to provide the debtor with Form 1099-C, Cancellation of Debt. (IRC 6050P) This form includes the following information: Box 1: Date of cancellation Box 2: Amount of debt canceled Box 3: The amount of accrued interest included in box 2. (As previously noted, the amount of interest is not included in income for a cash basis taxpayer. (IRC 108(e)(2)) As such, the cash basis taxpayer will subtract this amount from the Box 2 amount to arrive at the principal amount of debt canceled.) Box 4: Description of the debt Box 5: A checkbox to indicate whether the borrower was personally liable for the debt (recourse debt) has been added in the 2009 version of the form Box 6: A checkbox to indicate that cancellation was due to bankruptcy Box 7: The FMV of the property If the lender acquires the property by foreclosure or by abandonment by the borrower, but does not cancel any debt, the borrower may receive Form 1099-A, Acquisition or Abandonment of Secured Property. (IRC 6050J) This form includes the following information: Box 1: Date of acquisition or abandonment Box 2: The amount of principal outstanding Box 4: FMV of the property Box 5: A checkbox to indicate whether the borrower was personally liable for the debt (recourse debt) Box 6: Description of the property A lender may issue both Forms 1099-A and 1099-C if the lender cancels the debt in connection with acquisition of the property, e.g., foreclosure. However, in such a situation, the lender need only issue Form 1099-C. (Treas. Regs P-1(e)(3)) Spidell Publishing, Inc.

37 FORM 1099-C FORM 1099-A For individual taxpayers, the taxable amount of COD income is reported: On Schedule C if the debt was related to the trade or business; On Schedule E if the debt was related to rental property or another asset reported on Schedule E; On Schedule F if the debt relief is for farming debt; or On Form 1040, line 21, Miscellaneous Income, for personal residences and other personal forgiven debts. The capital gain or loss portion is reported on Schedule D, Capital Gains and Losses, or Form 4797, Sales of Business Property, as appropriate. In addition, file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to claim any exclusions under IRC 108. On this form, you report reduction of tax attributes including the election under IRC 108(b)(5) to apply the reduction first to reduce the basis of depreciable property. The instructions to Form 982 state that you must attach a statement to the return describing the transaction resulting in the reduction of basis under IRC Spidell Publishing, Inc

38 Spidell Publishing, Inc.

39 INCORRECT FORMS What should you do if the Form 1099-A or Form 1099-C contains incorrect information, such as the amount of debt canceled or the FMV of the property? First, contact the lender and ask to have the form corrected. If the lender won t issue a corrected form, then report the correct information on the return and attach a statement to the return explaining the difference in reporting. For example, many lenders will report, as the FMV of the property, the price at which the foreclosed property was sold at a trustee s sale. A trustee s sale is generally considered a forced sale and therefore, the selling price may be substantially less than the true FMV. Since a higher FMV will result in a lower amount of COD income, it is generally more advantageous for the taxpayer to report a higher FMV. Evidence of comparable sales, a realtor s opinion of value, or an appraisal should be obtained to support the FMV being reported when it is different from the amount shown on the Form 1099-C. PREPARING THE RETURNS Unfortunately, in most cases your software will not calculate what COD income qualifies for principal mortgage relief, insolvency, etc. These are calculations that you are going to need to do on your own. Let s run through an example to see how the calculations work and what data is reported on the taxpayer s returns. Spidell Publishing, Inc

40 Example of COD calculation In January 2007, Lila Bility purchased a home for $955,000, paying $55,000 down and obtaining a $900,000 interest-only non-recourse loan. In January 2008, when the value of the home had increased to $1,100,000, Lila refinanced her loan and took out an additional $50,000 to start a new business. After the refinance her debt was $950,000, and the loan was now a recourse loan. In November 2009, when the FMV of the property was $600,000, the lender foreclosed and canceled the $950,000 debt. At the time her home was foreclosed on, Lila had the following other assets and liabilities: $500 in her checking account; $5,000 in her savings account; A car worth $20,000, that she still owes $26,000 on; $27,000 in credit card debt; and $12,000 in student loans. Lila also has a $75,000 NOL carryover for federal and California purposes, from her business that failed last year. Let s calculate Lila s COD income and see how we would prepare her return Spidell Publishing, Inc.

41 Spidell Publishing, Inc

42 Because Lila had $50,000 of debt that didn t qualify for principal residence debt relief, without applying the insolvency provisions she would have $50,000 of taxable COD income. Because Lila s liabilities exceed her assets, she may use a combination of principal residence debt relief, and insolvency to eliminate her taxable COD income Spidell Publishing, Inc.

43 Spidell Publishing, Inc

44 Lila will need to file a Form 982 with her 1040, showing her basis adjustments due to the COD exclusions. Preparing the California return California s debt relief wasn t enacted until April 12, 2010, so a taxpayer who filed an original return without recognizing the relief may now file an amended return to exclude some or all of their COD income. You may also file returns for your clients whose returns were extended in hopes that California would enact some form of principal residence debt relief Spidell Publishing, Inc.

45 Claiming relief on an original return For taxpayers who have not yet filed their 2009 Form 540, California Resident Income Tax Return, or Form 540NR, California Nonresident or Part-Year Resident Income Tax Return, the taxpayer may file for debt relief on the original return. If the amount of debt relief for federal purposes is the same as the California limit, then no adjustment is necessary on Schedule CA. If the amount of debt relief for federal purposes is more than the amount for California, include the additional taxable amount for California on Schedule CA line 21f, column C. Example of California calculation Barney owns a home with recourse debt of $1,000,000; only $900,000 is qualified principal residence indebtedness. The FMV at the time of foreclosure is $700,000, and Barney s basis in the property is $900,000. For 2009, here is what Barney s federal and California COD would be: Federal Computation Step 1: Computing nonqualified principal residence indebtedness a. Total recourse debt $1,000,000 b. Subtract the lesser of qualified principal residence (900,000) indebtedness; or $2,000,000 c. Nonqualified debt 100,000 Step 2: Computing COD income a. Total recourse debt (from Step 1a) $1,000,000 b. Less FMV (700,000) c. COD income 300,000 d. Less nonqualified debt (from Step 1c) (100,000) e. Excludable COD $200,000 f. Taxable COD (2c minus 2e) $100,000 California Computation Step 1: Computing nonqualified principal residence indebtedness a. Total recourse debt $1,000,000 b. Subtract the lesser of qualified principal residence (800,000) indebtedness; or $800,000 c. Nonqualified debt $200,000 Step 2: Computing COD income a. Total recourse debt (from Step 1a) $1,000,000 b. Less FMV (700,000) c. COD income 300,000 d. Less nonqualified debt (from Step 1c) (200,000) e. Excludable COD (lesser of 2c - 2d, or $250,000) $100,000 f. Taxable COD (2c minus 2e) $200,000 Barney must enter $100,000 on the California Schedule CA, line 21f, column C to increase California income due to the difference in COD exclusion. The taxpayer must include a copy of their federal return, including Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and 1082 Basis Adjustment), with the original California tax return. California does not have a form similar to Form 982. Spidell Publishing, Inc

46 Taxable income on 540: Schedule CA: California 982: Spidell Publishing, Inc.

Presented by: David L. Rice, Esq. For CalCPA Pasadena Discussion Group. (c) David L. Rice

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