learning objectives introduction - tax workbook

© 2016 Land Grant University Tax Education Foundation, Inc. 541

FINANCIAL DISTRESS

16Cancellation-of-Debt

Income � � � � � � � � � � � � � � � � � 542Bad-Debt Deduction � � � � � � � � 557

Debt-Related Information Returns � � � � � � 566

Learning Objectives

After completing this session, participants will be able to perform the following job-related actions:

✔✔ Explain when to report cancellation-of-debt income and when that income can be excluded

✔✔ Report the reduction of tax attributes resulting from discharge of indebtedness

✔✔ Report business and nonbusiness bad debt

✔✔ Explain the information reported on Forms 1099-A, Acquisition or Abandonment of Secured Property

✔✔ Explain the information reported on Forms 1099-C, Cancellation of Debt

✔✔ Report information from Forms 1099-A and 1099-C on the taxpayer’s income tax return

Introduction

This chapter explains the income tax conse-quences of debt cancellation for the debtor and the creditor and the requirement that creditors file an information return. Canceled debt can result in an information reporting requirement for the creditor, taxable income for the debtor, and a bad-debt deduction for the creditor. However, debtors and creditors are sometimes confused about when the creditor should report the can-celed debt on an information return, when and how much cancellation-of-debt (COD) income the debtor must report, and when and what kind of bad-debt deduction the creditor can report.

FINAL COPYRIGHT 2016 LGUTEF

542 CANCELLATION-OF-DEBT INCOME

Loan Proceeds Are Not Income

While it seems unfair to require taxpayers to rec-ognize gain from sale proceeds that were used to pay debt, it should be noted that a loan is not rec-ognized as income when the taxpayer receives it�

The treatment of gain or loss from repossess-ing business use property depends on how the property was used in the business.

Property Held for Sale Taxpayers who use cash basis accounting can postpone the recognition of income on property they produce for sale in the ordinary course of business by postponing the sale of that property. Financial distress that forces a sale will trigger the recognition of income.

Example 16.2 Delayed Sale of Crop

Jose Gonzales deferred the recognition of income by deducting the cost of raising his crops in the year the crops were produced and by selling the crops in the following year. If his bank repos-sesses his 2016 crop in December 2016 to pay his crop loan, Jose must report the gain as if he sold his crop to the bank for its fair market value (FMV) at the time it was repossessed.

Property Used in a BusinessDifferent tax consequences can arise on the trans-fer of property used in a trade or business.

Depreciation RecaptureAll I.R.C. § 1245 property and I.R.C. § 1250 property that has been depreciated on an acceler-ated basis is subject to the depreciation recapture rules. These rules may require the taxpayer to report part or all of the gain that is realized on the transfer as ordinary income.

CANCELLATION-OF-DEBT INCOME This section explains the income tax consequences of financial distress�

Many taxpayers who are in financial distress have two types of transactions that trigger income tax consequences:

1. A transfer of assets that triggers recognition of gain or loss

2. A discharge of debt

Discharge of debt may result in the recogni-tion of income, or it may qualify for an exclusion under I.R.C. § 108. The exclusion may require a corresponding reduction in tax attributes, such as net operating losses (NOLs) or basis in assets. These rules are explained in the next section of the chapter.

The rules for one type of transaction cannot be applied to the other type of transaction.

Recognition of Gain or Loss

Financial distress often leads to the transfer of assets, whether through repossession, a forced sale of collateral by a lender, or a voluntary sale to pay off debts. In any of those cases, the trans-fer is a taxable event, and the taxpayer may owe income tax.

Example 16.1 Gain on Forced Sale

Lotta Debt missed several payments on a bank loan that was secured by appreciated XYZ, Inc. stock. The bank sold the stock, applied the pro-ceeds to the loan, and paid the excess funds to Lotta.

Lotta cannot avoid recognizing the gain on the sale of the stock. Even though the sale was involuntary, and most of the proceeds were used to pay her debt, Lotta must recognize gain equal to the difference between her basis in the stock and the sale price.


Inclusion of Cancellation-of-Debt Income 543

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Example 16.3 I.R.C. § 1245 Recapture

Cobbler Brown purchased a sewing machine (7-year property) in 2012 for $5,000. She claimed a total of $3,663 ($715 + $1,225 + $875 + $625 + $223) in depreciation in tax years 2012–2016. In 2016, when she sold the sewing machine for $2,000 to pay off some debts, her basis in the sewing machine was $1,337 ($5,000 – $3,663), so her realized and recognized gain is $663 ($2,000 – $1,337). Because the depreciation Cobbler had claimed was greater than her gain, she reports all of the $633 gain as ordinary income on her 2016 return.

I.R.C. § 1231 Gain or LossI.R.C. § 1231 property includes real and depre-ciable personal property used in a trade or busi-ness and held for more than 1 year. If I.R.C. § 1231 property is sold for more than its original purchase price, the amount of the sale price in excess of the original purchase price is an I.R.C. § 1231 gain. If I.R.C. § 1231 property is sold for less than its adjusted basis, the amount by which the adjusted basis exceeds the sale price is an I.R.C. § 1231 loss.

Example 16.4 I.R.C. § 1231 Gain

If Cobbler Brown from Example 16.3 sold her sewing machine for $5,300, she has a $3,963 gain ($5,300 − $1,337). She reports $3,663 of I.R.C. § 1245 depreciation recapture as ordinary income and the remaining $300 ($3,963 − $3,663) as I.R.C. § 1231 gain.

Example 16.5 I.R.C. § 1231 Loss

If Cobbler Brown from Example 16.3 sold her sewing machine for $900, she reports a $437 ($1,337 – $900) I.R.C. § 1231 loss.

Capital Gain, Ordinary Loss

If a taxpayer has a net I�R�C� § 1231 gain for a tax year, the net gain is treated as a long-term capital gain� If a taxpayer has a net I�R�C� § 1231 loss for a tax year, the net loss is deducted from ordinary income�

Inclusion of Cancellation-of-Debt Income

Because the borrower has an equal and offsetting obligation to repay a loan, there is no increase in wealth, and a loan is not reported as income. When principal payments are made on a loan, the payments are not deductible because the repay-ment obligation is reduced in an amount equal to the cash paid. Again, there is no change in wealth.

If, however, the loan is forgiven rather than paid off, the taxpayer has an increase in wealth because his or her obligation to repay the loan is reduced without an equal cash payment. That increase in wealth must generally be reported as cancellation-of-debt (COD) income.

Recognition of COD IncomeCOD income is generally equal to the difference between the principal balance owed on the debt and the amount accepted in satisfaction of it. If property is repossessed, its FMV is treated as a cash payment by the borrower.

Example 16.6 Recognition of COD Income

In 2014, Donald Debtor borrowed $20,000 to buy a $23,000 pickup for personal use. He made principal and interest payments as they came due in 2014 and 2015. In 2016, Donald lost his job and could not make the payments. The bank repossessed his pickup when it was worth $12,000 and his loan balance was $15,000, and the bank discharged all of Donald’s debt after the repossession.

Donald has no income from the $20,000 loan proceeds in 2014, and he has no deduction for the principal payments in 2014 and 2015. In 2016, he must report the repossession of the pickup as if he had sold it to the bank for its $12,000 value. He cannot deduct his $11,000 loss ($23,000 basis – $12,000 FMV) because he used the pickup for personal purposes. But he has $3,000 ($15,000 debt – $12,000 FMV) of COD income that he must report and may have to recognize.



Related Party Acquisition

When a relative of the debtor acquires the debt from a third party, the debtor is treated as acquir-ing the debt [I�R�C� § 108(e)(4)]� Therefore, if the debt is acquired for less than its face amount, the debtor must report COD income� Family mem-bers are defined as the debtor’s spouse, parents, children, and grandchildren, and spouses of the debtor’s children and grandchildren [I�R�C� § 108(e)(4)(B)]�

Cancellation Intended as a Gift

If the canceled debt is intended as a gift, the debtor has no COD income�

A debt may be written down without being discharged, so a taxpayer may have COD income while still owning the property and still owing a reduced amount of debt. This frequently occurs with credit card indebtedness.

Exceptions to COD IncomeI.R.C. § 108 grants several exceptions to inclusion of COD income in gross income. Two exceptions are based on the financial status of the taxpayer. The others are based on use of the borrowed funds. In addition, cancellation of certain student loans because of services performed by the bor-rower is not COD income.

Bankruptcy I.R.C. § 108(a)(1)(A) provides an exception if the debtor is in bankruptcy when the debt is discharged.

InsolvencyI.R.C. § 108(a)(1)(B) provides an exception if the taxpayer is insolvent when the debt is forgiven. Insolvency is defined as the excess of liabilities over the FMV of assets immediately before the discharge [I.R.C. § 108(d)(3)]. The COD excep-tion is limited to the insolvency amount.

Exempt Assets Must Be Included

Assets that are exempt from collection by credi-tors under state law must be included in the insolvency calculation [Carlson v. Commissioner, 116 T�C� 87 (2001)]�

Principal ResidenceI.R.C. § 108(a)(1)(E) provides an exception if the debt was qualified personal residence debt that was discharged in 2007 through 2016. This exception is discussed and illustrated in the sec-tion “Qualified Personal Residence Debt” later in this chapter.

State Law

State law exceptions may differ� For example, some states do not have an exclusion for dis-charge of indebtedness on a qualified personal residence�

Deductible If PaidIf the taxpayer could claim a deduction for pay-ing the debt, the debt discharged is excluded from gross income [I.R.C. § 108(e)(2)].

Deduction Would Offset Income

If I�R�C� § 108(e)(2) did not exempt the discharged debt from income, there would be an offsetting deduction because the debt would be deemed to be paid�

Example 16.7 Deductible Business Expense

A cash basis farmer does not deduct expenses such as interest or fertilizer until the expense is paid. Therefore, if a lender cancels the obligation to pay interest, or if a dealer cancels the obliga-tion to pay for fertilizer, the discharged debt is not reported as income because the expense would be deductible if the debt had been paid.



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Installment PurchaseIf the debt is owed by the original buyer of prop-erty to the original seller of that property, the dis-charge is not income to the buyer. Instead, the purchase price is adjusted by the amount of the discharge, so the seller has less gain to report and the buyer has a lower basis in the asset purchased [I.R.C. § 108(e)(5)].

Qualified Farm DebtIf the debtor is a farmer, and the debt is quali-fied farm debt, the discharged debt is excluded from gross income [I.R.C. § 108(a)(1)(C)]. Quali-fied farm debt is debt owed to an unrelated lender that was incurred directly in the taxpayer’s trade or business of farming. At least 50% of the taxpay-er’s aggregate gross receipts for the 3 years prior to the discharge must have been attributable to farming.

Qualified Real Property DebtIf the debtor is not a C corporation and the debt is qualified real property debt, the discharged debt is excluded from income [I.R.C. § 108(a)(1)(D)]. Qualified real property business indebtedness (QRPBI) generally is debt incurred for acquisi-tion of real property used in a trade or business that is secured by the real property.

Under Rev. Rul. 2016-15, 2016-26 I.R.B. 1060, a real estate developer may exclude COD income under the QRPBI exclusion only for indebtedness relating to depreciable property used in the developer’s trade or business, and not for indebtedness to purchase property held for sale to customers. Thus, indebtedness incurred by a real estate developer to construct rental prop-erty used in the developer’s leasing business will qualify as QRPBI because the property is depre-ciable. Property held for sale to customers is not depreciable, and thus debt incurred to construct the property is not QRPBI and is not excludable under I.R.C. § 108(a)(1)(D).

The amount excluded may not exceed the excess (if any) of

■■ the outstanding principal amount of such indebtedness (immediately before the dis-charge), over

■■ the FMV of the real property reduced by the outstanding principal amount of any other QRPBI secured by such property.

In addition, the amount excluded may not exceed the aggregate adjusted bases of depre-ciable real property determined after any basis reductions to other depreciable property held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of such discharge).

C.C.A. 2016-23-009 (March 2, 2016) clarifies the limit on the QRPBI exclusion. The taxpayer asserted that, for purposes of the exclusion limita-tion in I.R.C. § 108(c)(2) and Treas. Reg. § 1.108-6(a), the net FMV is the FMV of the single item of real property to which the discharged debt is QRPBI, reduced by the amount of other debt secured by such property but that is QRPBI with respect to any item of real property held by the taxpayer.

The IRS concludes that, for purposes of cal-culating the excess of the outstanding principal of the debt over the net of the FMV of the prop-erty and other QRPBI secured by the property, the only property to consider is the property that qualified the indebtedness as QRPBI. Thus, the formula begins with the total FMV of the single item of real property to which the discharged debt is QRPBI and then reduces that total by the sum of all other debts that are secured by, and QRPBI with respect to, only that item of real property.

Grantor Trusts and Disregarded EntitiesThe IRS issued final regulations that apply the COD income exclusions to grantor trusts and dis-regarded entities. Treas. Reg. § 1.108-9 provides that, for purposes of applying the I.R.C. § 108 bankruptcy and insolvency exclusions for COD income to grantor trusts and disregarded enti-ties, the term taxpayer refers to the owner of the grantor trust or the disregarded entity, and not the grantor trust or disregarded entity itself.

Thus, the insolvency exception is available only to the extent the owner is insolvent, and the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court’s jurisdiction. The final regulations make no substantive changes to the 2011 proposed regulations.



ReacquisitionA reacquisition is an acquisition of an applicable debt instrument by the debtor who issued it or who is otherwise the obligor for it. This includes an acquisition by a person that is related to the debtor within the meaning of I.R.C. § 108(e)(4).

Coordination with ExclusionsIf a taxpayer elects to defer COD income arising from the reacquisition of a debt instrument, the I.R.C. § 108(a)(1) exclusions from gross income for bankruptcy, insolvency, qualified farm debt, and qualified real property debt do not apply to that COD income for the year of the election or any subsequent year.

Reduction in Tax AttributesIn general, I.R.C. § 108 does not allow the tax-payer to permanently avoid income taxes on COD income that is not recognized. Instead, it postpones the taxes on that COD income by requiring the taxpayer to reduce tax attributes that would otherwise be available to reduce tax liability in a future year. Taxpayers pay a price for current-year income exclusion by increasing potential tax liability in future years by an amount roughly equal to the current-year decrease.

The tax attribute reduction rules differ for the various exceptions. If a debtor must reduce tax attributes, he or she must attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082, Basis Adjust-ment), to his or her tax return.

Deductible If PaidThere is no reduction of tax attributes for COD income that qualifies for the “deductible if paid” exception. The price is paid by not allowing the taxpayer to claim the deduction.

Installment PurchaseNo tax attributes are reduced for COD income that qualifies for the installment purchase excep-tion. However, the buyer pays the price by reduc-ing the purchase price, which reduces the basis in the assets that were purchased.

Ordering Rules for Exceptions

If a taxpayer qualifies for more than one of the I�R�C� § 108 exceptions, the exception that is high-est in the following list is applied� However, a taxpayer can elect to apply the insolvency excep-tion before the qualified principal residence exception�

■■ Deductible if paid■■ Installment purchase■■ Bankruptcy■■ Qualified principal residence■■ Insolvency■■ Qualified farm debt■■ Qualified real property debt

Reacquisition of Debt Instruments in 2009 and 2010If an applicable debt instrument was reacquired at a discount during calendar year 2009 or 2010, the debtor may have elected to defer the COD income arising from the reacquisition. The deferred COD income is included in the taxpay-er’s gross income ratably over 5 tax years, begin-ning in 2014.

Applicable Debt InstrumentAn applicable debt instrument can be issued by a C corporation or by any other person in con-nection with the person’s conduct of a trade or business. A debt instrument includes a bond, debenture, note, certificate, or other instrument or contractual arrangement constituting indebt-edness within the meaning of I.R.C. § 1275(a)(1).

AcquisitionAn acquisition includes (without limitation) an acquisition for cash, the exchange of a debt instru-ment for another debt instrument, the exchange of corporate stock or a partnership interest for a debt instrument, the contribution of a debt instru-ment to the capital of the issuer, and the complete forgiveness of a debt instrument by a holder.



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7. Foreign tax credit carryovers: Any carryover to or from the tax year of the discharge for pur-poses of determining the amount of the credit allowable under I.R.C. § 27

Although basis reduction is fifth on this prior-ity list, a taxpayer may elect to reduce the basis of depreciable assets before reducing the other tax attributes [I.R.C. § 108(b)(5)]. The election is made on line 5 of Form 982. The amount to which the election applies may not exceed the aggregate adjusted bases of the depreciable prop-erty held by the taxpayer as of the beginning of the tax year following the tax year in which the discharge occurs.

Election to Treat Certain Real Property as Depreciable Property

If a taxpayer elects to reduce the basis of depre-ciable property first, he or she can also elect to treat real property that is inventory or that is held primarily for sale in the ordinary course of business as depreciable property [I�R�C� § 1017(b)(3)(E)]� The election also applies to the reduc-tion of basis in depreciable property under the qualified farm indebtedness exception [I�R�C� § 1017(b)(4)(C)], but not to the reduction of basis in depreciable real property under the qualified real property business indebtedness exception [I�R�C� § 1017(b)(3)(F)]�

Student LoansCertain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if the stu-dent works for a certain period of time in certain professions for any of a broad class of employers.

The student does not have income if the loan is canceled after the student agreed to this provi-sion and then performed the services required. To qualify, the loan must have been made by

1. the federal government; a state or local gov-ernment; or an instrumentality, agency, or subdivision thereof;

Principal ResidenceThe only tax attribute reduced for COD income excluded under the principal residence excep-tion (discussed later in this chapter) is the basis of the principal residence [I.R.C. § 108(h)(1)].

Qualified Real Property DebtThe only tax attribute reduced for COD income excluded under the qualified real property debt exception is the basis of depreciable real prop-erty. This basis reduction occurs at the earlier of two events:

1. The end of the tax year of the discharge2. Immediately before a disposition of the

property

Bankruptcy, Insolvency, and Qualified Farm DebtCOD income exclusions resulting from the bank-ruptcy, insolvency, and qualified farm indebted-ness exceptions generally require taxpayers to reduce the following seven tax attributes in the order listed. This order is reflected on Form 982.

1. Net operating loss (NOL): Any NOL for the tax year of the discharge, and any NOL carry-over to that tax year

2. General business credit: Any carryover of an amount allowable as a credit under I.R.C. § 38, to or from the tax year of the discharge

3. Minimum tax credit: The amount of the mini-mum tax credit available under I.R.C. § 53(b) as of the beginning of the tax year immedi-ately following the tax year of the discharge

4. Capital loss carryovers: Any net capital loss for the tax year of the discharge, and any capital loss carryover to that tax year under I.R.C. § 1212

5. Basis: In general, the basis of the taxpayer’s property (some special rules are explained in “Limit on Basis Reduction” later in this section)

6. Passive activity loss and credit carryovers: Any passive activity loss or credit carryover of the taxpayer under I.R.C. § 469(b) from the tax year of the discharge


548 CANCELLATION-OF DEBT-INCOME

Amount of Attribute ReductionAttributes other than credits are reduced by one dollar for each dollar of COD income that is excluded. The credits in items 2, 3, 6, and 7 listed earlier are reduced by one dollar for every three dollars of COD income that is excluded.

Example 16.8 Attribute Reduction

Doug Hale owns and operates a real estate busi-ness. He was unable to make the payments on his $5,000,000 operating loan as they came due. The operating loan was secured by a mortgage on his office building (including the land), a secu-rity interest in his equipment, and a mortgage on the real estate he held for sale. His bank agreed to restructure his debt by forgiving $1,000,000 of principal and extending the period for repay-ing the remaining $4,000,000 of debt. Doug had $3,500,000 of assets and no other debt, so he was insolvent both before and after the debt dis-charge. Doug’s tax attributes before the discharge are shown in Figure 16.1.

FIGURE 16.1 Doug’s Tax Attributes

Tax Attribute Amount

NOL carryover $ 400,000

Basis in office building 60,000

Basis in land under office building 90,000

Basis in equipment 50,000

Basis in real estate held for sale 5,000,000

Total $5,600,000

Doug does not have to recognize any of the $1,000,000 debt discharge as COD income because he was insolvent before and after the discharge. However, he must reduce his tax attri-butes as a result of the discharge. If Doug does not elect to reduce the basis of depreciable property first, he must first reduce his $400,000 NOL to zero, as shown on Form 982 in Figure 16.2. He then reduces the basis in his property in the fol-lowing order:

1. Office building and land2. Equipment3. Real estate held for sale (on a pro rata basis as

shown in the statement he attaches to Form 982, shown in Figure 16.3)

2. 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

3. an educational institutiona. under an agreement with an entity

described in item 1 or 2 of this list that pro-vided the funds to the institution to make the loan, or

b. 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 governmen-tal unit or a tax-exempt section 501(c)(3) organization.

Services Provided to the Educational Institution

A taxpayer has income if the student loan was made by an educational institution and is can-celed because of services the taxpayer performed for the institution or other organization that provided the funds�

Education loan repayments are not taxable if they are from

■■ the National Health Service Corps Loan Repayment Program (NHSC Loan Repay-ment Program),

■■ a state education loan repayment program eligible for funds under the Public Health Service Act, or

■■ any other state loan repayment or loan for-giveness program that is intended to provide for the increased availability of health ser-vices in underserved or health professional shortage areas.



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FIGURE 16.2 Doug’s Form 982

FIGURE 16.3 Attachment for Doug’s Form 982

Statement for 2016 Form 982, line 10aDoug Hale, SSN 108-10-1017

AssetBasis before Reduction Allocation of Basis Reduction

Basis Reduction

Basis after Reduction

Office building $ 60,000 Entire basis $ 60,000 $ 0

Land under office building 90,000 Entire basis 90,000 0

Equipment 50,000 Entire basis 50,000 0

Real estate held for sale

Parcel A $ 500,000($500,000 ÷ $5,000,000) ×

$400,000 $ 40,000 460,000

Parcel B 1,750,000($1,750,000 ÷ $5,000,000)

× $400,000 140,000 1,610,000

Parcel C 1,250,000($1,250,000 ÷ $5,000,000)

× $400,000 100,000 1,150,000

Parcel D 1,500,000($1,500,000 ÷ $5,000,000)

× $400,000 120,000 1,380,000

Total real estate held for sale 5,000,000 400,000 4,600,000

Total assets $5,200,000 $ 600,000 $ 4,600,000



Therefore, he elects to reduce the basis of depre-ciable property first under I.R.C. § 108(b)(5), and he elects to treat his real estate held for sale as depreciable property under I.R.C. § 1017(b) (3)(E). The order of reducing the bases of depre-ciable property is the same as in Example 16.8—the basis of property used in the trade or business is reduced first, followed by other trade or busi-ness property. Doug would like to save the basis of the parcel he plans to sell in 2017, but he must allocate the $890,000 ($1,000,000 − $60,000 office building − $50,000 equipment) reduction of bases in land held for sale to all of the parcels—including the one he plans to sell.

Doug’s Form 982 and the attachment for it are shown in Figures 16.4 and 16.5.

Order of Basis Reduction

See the discussion of basis reduction under I�R�C� § 1017 later in this chapter for an explanation of the ordering rules for reducing basis�

Example 16.9 Election to Reduce Depreciable Basis First

The facts are the same as in Example 16.8, except that Doug wants to save his NOL to offset income he expects in 2017 from the sale of real estate held for sale in the ordinary course of business.

FIGURE 16.4 Doug’s Form 982



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Limit on Basis ReductionUnder the bankruptcy and insolvency excep-tions, the taxpayer retains an aggregate basis in all assets that is equal to the debt that remains after the discharge [I.R.C. § 1017(b)(2)]. By contrast, the taxpayer’s entire basis in qualified property is subject to reduction under the qualified farm debt exception.

The basis reduction limit for bankruptcy and insolvency does not apply if the taxpayer elects to reduce the basis of depreciable assets before reducing the other tax attributes [I.R.C. § 1017(b)(2)]. The reduction of basis is treated as a deduction for depreciation for purposes of I.R.C. §§ 1245 and 1250 [I.R.C. § 1017(d)].

Example 16.10 Basis Reduction Limit

Elaine Carter is insolvent, and she has no tax attributes other than a $75,000 aggregate basis in assets. She had $100,000 of debt just before her banker discharged $40,000 of debt, leaving her with $60,000 of debt. Elaine must reduce her asset basis by only $15,000 ($75,000 – $60,000), but she may exclude the entire $40,000 of COD income under the insolvency exception.

COD Income Exceeding Tax AttributesIf all tax attributes are reduced to zero, and there is excess COD income, the consequences depend on whether the COD income was excluded under the qualified farm debt exception or under the bankruptcy or insolvency exceptions. If COD income is excluded by the bankruptcy or insol-vency exceptions, the excess is not recognized as income. In other words, the taxpayer never pays a price for the exclusion of additional COD income.

If COD income is excluded under the quali-fied farm debt exception, the exclusion is limited by the taxpayer’s tax attributes. COD income in excess of the tax attributes must be recognized as income.

Qualified Farm Debt Exception

When COD income is excluded under the quali-fied farm debt exception, the basis reduction applies only to assets used or held for use in a trade or business or for the production of income� The basis of personal use assets, such as a home or car, cannot be reduced to avoid recognition of income under the qualified farm debt exception�

FIGURE 16.5 Attachment for Doug’s Form 982

Statement for 2016 Form 982, line 10aDoug Hale, SSN 108-10-1017

Asset

Basis before

Reduction Allocation of Basis ReductionBasis

ReductionBasis after Reduction

Office building $ 60,000 Entire basis $ 60,000 $ 0

Equipment 50,000 Entire basis 50,000 0

Real estate held for sale

Parcel A $ 500,000($500,000 ÷ $5,000,000)

× $890,000 $ 89,000 411,000

Parcel B 1,750,000($1,750,000 ÷

$5,000,000) × $890,000 311,500 1,438,500

Parcel C 1,250,000($1,250,000 ÷

$5,000,000) × $890,000 222,500 1,027,500

Parcel D 1,500,000($1,500,000 ÷

$5,000,000) × $890,000 267,000 1,233,000

Total real estate held for sale 5,000,000 890,000 4,110,000

Total assets $5,110,000 $ 1,000,000 $4,110,000



2. Personal property used in a trade or business or held for investment (other than inventory, notes receivable, or accounts receivable) that secured the discharged indebtedness imme-diately before the discharge

3. Remaining property used in the trade or busi-ness or held for investment (other than inven-tory, notes or accounts receivable, and real property held for sale to customers)

4. Inventory, notes receivable, accounts receiv-able, and real property held for sale to customers

5. Property that is not used in a trade or business and is not held for investment

Example 16.11 Order of Basis Reduction

Paige Turner owns a Christmas ornament manu-facturing business. She has a large payroll and a large operating loan because her sales are sea-sonal. The amount of her loans and the collateral that secures them are shown in Figure 16.6.

Reason for Basis Reduction Limitation

The reason for the basis reduction limitation is to prevent the taxpayer from owing additional income taxes if the remaining assets are sold for an amount equal to the remaining debt�

Order of Basis ReductionThe order for reducing the basis in assets for COD income that is excluded under the bankruptcy or insolvency exceptions is set out in Treas. Reg. § 1.1017-1(a) as follows:

1. Real property used in a trade or business or held for investment (other than real property held for sale to customers) that secured the discharged indebtedness immediately before the discharge

FIGURE 16.6 Paige’s Debt and Security

Purpose of Loan Collateral Amount

Purchase building and land Building and land $ 100,000

Purchase equipment Equipment 30,000

Operating loan Building, land, equipment, and inventory 500,000

Total $ 630,000

Paige’s assets, their bases, and their FMVs are shown in Figure 16.7.

FIGURE 16.7 Paige’s Assets

Asset Basis FMV

Land and buildings $ 100,000 $ 125,000

Machine #1 50,000 20,000

Machine #2 200,000 60,000

Machine #3 250,000 35,000

Total $ 600,000 $ 240,000

Paige was unable to make the payments on her operating loan because of the bad economy. Her lender forgave $180,000 of the operating loan and refinanced the remaining $320,000 ($500,000 – $180,000). Because Paige was insol-vent both before and after the debt discharge, she does not have to recognize any COD income. However, she must reduce her bases in assets by the lesser of the $180,000 debt discharge or the $150,000 difference between her $600,000 asset basis and her $450,000 ($630,000 – $180,000) remaining debt.

Because the debt that was discharged was secured by Paige’s real property, she must first reduce the $100,000 basis of her real property to zero. Because the debt was also secured by her equipment, Paige must prorate the remaining $50,000 basis reductions among the bases of her equipment, as shown in Figure 16.8.



16the amount was included in income. The claim is filed on Form 1040X, Amended U.S. Individual Income Tax Return, if the statute of limitations for filing a claim is still open.

Claim-of-Right Rule Does Not Apply

If a taxpayer repays an amount that was reported as income in an earlier year, I�R�C� § 1341 allows the taxpayer to compute the refund for the tax paid in the earlier year by treating the repayment (1) as a deduction in the year it was repaid or (2) as a reduction of the income reported in the earlier year�

In S�C�A� 2002-35-030 (June 3, 2002), the IRS concluded that I�R�C� § 1341 does not apply to tax-payers who claim a refund for COD income that was reported as income and repaid in a later year for two reasons�

1� I�R�C� § 1341 applies only to situations in which it appears that the taxpayer has an “unre-stricted right” to the income� In the case of COD income, the taxpayer does not have a right to income�

2� A requirement for applying I�R�C� § 1341 is that the taxpayer would otherwise be entitled to a deduction for the repayment under some other section of the Internal Revenue Code� Because payments of personal loans are gener-ally not deductible under any provision of the Internal Revenue Code, a taxpayer who takes an amount into income because of a cancella-tion of indebtedness and who later paid that amount cannot deduct the payment�

Therefore, a taxpayer’s only choice is file an amended return for the year the COD income was reported�

Bankrupt Taxpayers

If the debtor is in bankruptcy, the basis of exempt property under section 522 of the US Bankruptcy Code is not reduced [I�R�C� § 1017(c)(1)]� For example, some equity in a personal residence is exempt from being taken from the debtor in a bankruptcy proceeding� Thus, the personal residence basis cannot be reduced below that exempt equity�

For the qualified farm debt exception, only the basis in property held for use in a trade or busi-ness (or for the production of income) is reduced. The order for reducing basis is as follows:

1. Depreciable property2. Land held for use in the trade or business of

farming3. Other qualified property

Timing of Basis Reduction

The reduction in basis occurs at the end of the tax year of the discharge� This permits farmers to purchase additional qualified property before the end of the year to increase the basis that can be used to exclude COD income�

Repayment of Canceled DebtsIf a taxpayer included a canceled amount in income and later paid the debt, he or she may be able to file a claim for a refund for the year

FIGURE 16.8 Reduction of Bases in Equipment

Asset Basis Portion of Total Bases

Portion of $50,000

ReductionBasis after Reduction

Machine #1 $ 50,000 ($50,000 ÷ $500,000) × $50,000 $ 5,000 $ 45,000

Machine #2 200,000($200,000 ÷ $500,000) ×

$50,000 20,000 180,000

Machine #3 250,000($250,000 ÷ $500,000) ×

$50,000 25,000 225,000

Total $ 500,000 $ 50,000 $ 450,000



However, if Misha’s loan is nonrecourse, all of the discharged debt is treated as the sales price, and none of it is treated as COD income [Commissioner v. Tufts, 461 U.S. 300 (1983)]. Thus, Misha’s I.R.C. § 1231 gain is $150,000 ($500,000 – $350,000), and his COD income is zero.

Qualified Personal Residence Debt

The value of some taxpayers’ homes is now less than their mortgage balances, and the taxpayers have walked away from the debt. Example 16.13 illustrates the rules that apply if the creditor fore-closes and the rules that apply if the debtor initi-ates the transfer of a qualified residence.

Example 16.13 Transfer of Home to Creditor

Jason Hall acquired his principal residence in 2005 for $250,000. He paid $5,000 and obtained a $245,000 mortgage. Jason paid $10,000 on the loan principal before losing his job, but he can no longer afford the mortgage payments. The prop-erty is now worth only $200,000, but the mort-gage balance is $235,000 ($245,000 – $10,000). Jason plans to walk away and let the lender fore-close on the house. The lender will cancel the bal-ance of the mortgage.

Question 1.Does Jason have a deductible loss?

Answer 1.No. The transfer is treated as the sale of a personal asset, and the loss is not deductible.

Question 2.Will Jason be taxed on COD income?

Answer 2.Jason does have a $35,000 discharge of debt ($235,000 mortgage balance minus the $200,000 FMV of the house). However, the discharged debt can be excluded from his income as qualified principal residence indebtedness (QPRI) under I.R.C. § 108(a)(1)(E).

Question 3.Is there any tax consequence from the exclusion?

Distinguishing COD Income and Gain from Transfer of Assets

When property is transferred and debt is can-celed, it is not always easy to distinguish COD income from capital gain income. The type of debt—recourse, nonrecourse, or purchase-money—makes a difference.

Example 16.12 Deed in Lieu of Foreclosure

Misha Yorblonski had a $500,000 loan outstand-ing at his local bank, secured by a mortgage on his office building. His tax basis in the building was $350,000, and its FMV was $400,000. The building was depreciated using a straight-line method. Misha became unable to make pay-ments on the loan. To avoid the costs of repos-session, and because the bank did not think the loan would ever be fully repaid anyway, the bank agreed to cancel Misha’s debt if he voluntarily turned the office building over to the bank. If Misha provided a deed in lieu of foreclosure, how much gain must he report, and how much COD income does he have?

The general rule is found in Treas. Reg. § 1.1001-2(a)(1), which provides that the amount realized from a sale or other disposition includes the liabilities from which the debtor is discharged. But the general rule is subject to the following two exceptions:

1. If the debt is a recourse debt, the amount real-ized on the transfer does not include COD income [Treas. Reg. § 1.1001-2(a)(2)].

2. For a purchase-money debt, the amount real-ized does not include discharged debt that reduced the basis of the property [Treas. Reg. § 1.1001-2(a)(3)].

Therefore, if Misha’s loan is a recourse loan, he will have both I.R.C. § 1231 gain and COD income. The $50,000 excess of the building’s $400,000 FMV over its $350,000 basis is I.R.C. § 1231 gain, and the $100,000 amount by which the $500,000 discharged debt exceeds the build-ing’s $400,000 FMV is COD income.


Qualified Personal Residence Debt 555

16

FIGURE 16.9 Loss on Transfer

Deemed sales price (FMV) $200,000

Adjusted basis (250,000)

Loss on transfer $50,000

Basis is the only tax attribute that is potentially reduced when the QPRI exclusion applies. Other tax attributes, such as NOLs, are not affected. Figure 16.10 shows Jason’s Form 982.

Answer 3.Although the QPRI amount excluded from income reduces Jason’s basis in his residence, the reduction does not take place until the beginning of the tax year following the year the debt was discharged [I.R.C. § 1017(a)]. Because Jason’s deemed sale to the lender occurs first, there is no basis reduction. The deemed sale therefore results in the nondeductible loss calculated in Figure 16.9.

FIGURE 16.10 Jason’s Form 982



Question 6.What if Jason had a gain on the deemed sale?

Answer 6.If Jason realized a gain on the deemed sale, the gain could qualify for exclusion under I.R.C. § 121, “Exclusion of gain from sale of principal residence.” However, if the FMV of the property exceeded the mortgage debt, he is unlikely to simply turn it over to the lender.

Exclusion Also Applies to Loan Restructuring

The QPRI exclusion of COD income applies to debt that is reduced through mortgage restructuring as well as debt that is forgiven in connection with foreclosure� Up to $2,000,000 of acquisi-tion debt ($1,000,000 if married filing separately) can be QPRI� The debt reduction must be directly related to a decline in the home’s FMV or to the taxpayer’s financial condition [I�R�C� § 108(h)(3)]� The exclusion applies to QPRI forgiveness during the calendar years 2007–2016�

Question 7.What are the income tax consequences if the bank restructured the loan and discharged the $35,000 of debt in 2016 (leaving Jason with a $200,000 mortgage), and Jason sold the house for $220,000 in 2017?

Answer 7.The discharge of debt is excluded from Jason’s 2016 income, but it reduces Jason’s basis in the house at the beginning of 2017 to $215,000 ($250,000 – $35,000). Jason therefore realizes $5,000 of gain in 2017 when he sells the house for $220,000. That gain is excludable under I.R.C. § 121 because it is gain on the sale of a qualified principal residence.

If Jason previously deducted $2,500 of depre-ciation on his home office, his I.R.C. § 121 exclu-sion is limited to $2,500 ($5,000 – $2,500) because the portion of gain equal to depreciation is not eligible for the exclusion. That $2,500 of gain is unrecaptured section 1250 gain, potentially sub-ject to the maximum 25% long-term capital gains tax rate.

Question 4.What if Jason has been deducting expenses (including $2,500 of depreciation) for a home office? He used one room solely for a qualifying office. Can he deduct 10% of his loss if the office was 10% of his home?

Answer 4.Because his basis is reduced by the deprecia-tion allowed or allowable, his adjusted basis in the entire property becomes $247,500 ($250,000 – $2,500), and his loss is reduced to $47,500 ($200,000 – $247,500). This loss is still a nonde-ductible personal loss. Treas. Reg. § 1.121-1(e) provides that if a home includes both residential and nonresidential areas within the same dwelling unit, no allocation is made on disposition. Jason cannot treat the foreclosure as two separate sales to recognize a loss on the business use portion.

Question 5.Does it matter if Jason is insolvent or files for bankruptcy?

Answer 5.The COD income is still excluded. However, the QPRI exclusion of COD income is available even to a solvent taxpayer, and it takes precedence over the insolvency exception—unless the taxpayer elects to use the insolvency exception. By contrast, debt written off in bankruptcy must be excluded under the bankruptcy provision—the taxpayer cannot elect to use the QPRI exclusion instead of the bankruptcy exclusion.

Bankruptcy and Insolvency Exclusions Reduce Attributes

Under the bankruptcy and insolvency exclusions, all tax attributes are subject to reduction� These include NOLs, capital loss carryovers, and basis in all assets owned by the taxpayer� Therefore, the $35,000 discharge is more likely to reduce tax attributes if the taxpayer files for bankruptcy�


Business Bad Debts 557

16

business of the taxpayer at the time the debt becomes worthless [Treas. Reg. § 1.166-5(b)(1)]. Whether the debt is a business or nonbusiness debt when it was created or acquired is a question of fact in each particular case. The determination is substantially the same as the determination of whether a loss was incurred in a trade or business for purposes of deducting business losses under I.R.C. § 165(c)(1) [Treas. Reg. § 1.166-5(b)].

Example 16.14 Created in Course of Business

Sandy Beach owned and operated an interior design business. In 2014, she sent Neil Down an invoice for $400 for interior decorating advice. When Sandy sold her business to Pete Bogg in 2015, Neil had not paid the $400 invoice. Sandy retained the claim against Neil. In 2016, Neil declared bankruptcy, and Sandy’s claim against him became worthless.

Because Sandy incurred the debt in the course of her business, the relationship of the debt to her business at the time it became worthless does not matter. It is a business debt [Treas. Reg. § 1.166-5(d), Example 1].

Related to BusinessIn contrast to the requirement for debt created or acquired in a trade or business, the taxpayer’s use of the borrowed funds is of no consequence for meeting the requirement that the debt must be related to the taxpayer’s business at the time it became worthless [Treas. Reg. § 1.166-5(b)(2)].

Example 16.15 Related to Business

If Sandy from Example 16.14 sold her $400 claim against Neil to Pete Bogg when she sold her business to him, the debt does not meet the first requirement for being a business debt because Pete did not create or acquire the debt in the course of his business. However, the debt was a business debt when it became worthless in 2016 because it was related to Pete’s business at the time it became worthless.

BAD-DEBT DEDUCTION A creditor that is unable to collect a debt may be allowed to claim a bad-debt deduction� This section discusses the timing and character of bad-debt deductions�

Taxpayers who are unable to collect a debt owed to them may be able to report their loss on their tax return if they can show the debt is worthless. If the debt was a business debt, the taxpayer may be allowed to reduce ordinary income by reporting a bad-debt deduction. If the debt was a nonbusi-ness debt, the taxpayer may be allowed to report a short-term capital loss.

Business Bad Debts

Taxpayers can claim a bad-debt deduction in the year a business debt becomes partially or totally worthless.

Definition of Business DebtI.R.C. § 166(d)(2) defines business debts by exclud-ing the following debts from the definition of non-business debts:

1. Debts that were created or acquired in the taxpayer’s trade or business

2. Debts that were related to the taxpayer’s trade or business at the time they become worthless

Only One Requirement

Taxpayers do not have to meet both business debt requirements� If the debt was created or acquired in the taxpayer’s trade or business, the debt’s relationship to a trade or business of the taxpayer at the time it became worthless does not matter� If the debt was related to the tax-payer’s trade or business at the time it became worthless, it does not matter how the borrowed funds were used�

Created or Acquired in a BusinessIf a debt was created or acquired in the course of a trade or business of the taxpayer, it is a busi-ness debt at the time it becomes worthless regard-less of the relationship of the debt to a trade or


558 BAD-DEBT DEDUCTION

Example 16.16 Loan to a Supplier

Emmanuel Miller builds specialized farm machinery and relies on Metal Fabricator, Inc. to supply custom-made parts for the machinery. Metal Fabricator had a cash flow problem and asked Emmanuel for a short-term $100,000 loan to meet its payroll until the company received payment on a large order it had filled. Emmanuel loaned the money to Metal Fabricator on Decem-ber 18, 2015, because he would have to pay more for the parts Metal Fabricator supplied if Metal Fabricator went out of business. Emmanuel’s loan to Metal Fabricator is a business debt.

Debts of a PartnerCreditors of partnerships can collect unpaid debts of the partnership from any of the general partners. If Partner A pays Partner B’s share of partnership debt, Partner A generally has a claim against Partner B for B’s debt paid by A. If the partnership debt was a business debt, A’s claim against B is a business debt.

Loans to an EmployerIf a taxpayer’s employer is in financial difficulty and the taxpayer loans money to that employer to keep his or her job, the debt is a business debt.

Limit on the DeductionThe business bad-debt deduction is limited to the taxpayer’s basis in the debt.

Accounts ReceivableOutstanding amounts due for sales, services, rents, and interest are a common form of busi-ness debt. Because taxpayers who use the cash method of accounting do not report income until they receive payment, they generally do not have an income tax basis in their accounts receivable for those sales, services, rents, or interest. There-fore, they have no bad-debt deduction when an account receivable becomes worthless.

Example 16.17 Cash Accounting Method

If Sandy from Example 16.14 uses the cash method of accounting, she cannot deduct a busi-ness bad debt in 2016 when the debt became worthless because she had not included the $400 amount Neil owed her in income.

Question 1.If Sandy sold the claim against Neil to her sister Coral Beach, who is not in the business of lending money, instead of to Pete, was the claim a business debt when it became worthless in 2016?

Answer 1.No, Coral did not meet either of the two business debt requirements. Although Sandy acquired the debt in the course of her business, Coral did not. Coral also has no trade or business to which the debt was related at the time it became worthless [Treas. Reg. § 1.166-5(d), Example 2].

Question 2.If Sandy died in 2015 and left her business, including the claim against Neil, to her son, Sonny Beach, was the claim a business debt when it became worthless in 2016?

Answer 2.Yes. Although the debt does not meet the first requirement for being a business debt because Sonny did not create or acquire the debt in the course of his business, it was a business debt when it became worthless in 2016 because it was related to Sonny’s business at the time it became worth-less [Treas. Reg. § 1.166-5(d), Example 3].

Common Business DebtsTransactions that commonly create business debts include loans to clients and suppliers, debts of a partner, loans to an employer, and loan guar-antees (discussed later under “Rules for Both Business and Nonbusiness Bad Debts”).

Loans to Clients and SuppliersBusinesses sometimes loan money to a client or customer so that the client or customer remains in business and continues to buy services or goods from the taxpayer. Such loans meet the require-ment of being created or acquired in the course of a trade or business and therefore are business debts. Similarly, loans to a supplier, distributor, or employee so that the borrower can continue to supply inputs or provide services to the business qualify as business loans.


Business Bad Debts 559

16

partially worthless. They can charge it off and deduct it in a later year, but not after the year it becomes totally worthless.

Charge Off Partially Worthless Debt

Taxpayers may want to charge off and deduct partially worthless debt in the earliest year it is arguably partially worthless� If the IRS determines it was not partially worthless in that year, the charge-off in the earlier year meets the charge-off requirement for a later year in which the IRS agrees it became worthless�

If a taxpayer does not charge off the debt in the earlier year, he or she cannot deduct it for that year even if the IRS later agrees it became worthless in the earlier year�

Taxpayers who did not deduct a partially bad debt on their original return for the year it became partially worthless can file a claim for a credit or refund on an amended return by the later of

■■ 3 years from the date they filed their original return, or

■■ 2 years from the date they paid the tax.

Totally Worthless DebtIn the year a debt becomes totally worthless, the taxpayer can deduct the entire amount, subject to the basis limit and reduced by any amount deducted as a partially worthless debt in an ear-lier year.

Unlike the deduction for a partially worthless debt, the taxpayer does not have to charge off the debt on his or her books. However, if the IRS rules that the debt was only partially worthless that year, the taxpayer can claim a deduction for the partially worthless debt only if it was charged off in that year.

Taxpayers who did not deduct a business bad debt on their original return for the year it became totally worthless can file a claim for a credit or refund on an amended return by the later of



Taxpayers who use the accrual method of accounting generally report income as they earn it. Their basis in a business debt is the amount they previously reported in income.

Example 16.18 Accrual Accounting Method

If Sandy from Example 16.14 uses the accrual method of accounting and included the $400 Neil owed her in her 2014 income, she can deduct a business bad debt in 2016 when the debt became worthless.

If a taxpayer buys an account receivable for less than its face value, and it subsequently becomes worthless, the most the taxpayer can deduct is the amount he or she paid for it.

Timing of the DeductionThe timing of a business bad-debt deduction depends on the method the taxpayer uses to claim the deduction and whether the debt is partially or totally worthless. Generally, taxpayers must use the specific charge-off method, but some taxpay-ers can use the nonaccrual-experience method.

Loan Guarantee

A taxpayer’s payment on a loan he or she guar-anteed is a bad debt for the taxpayer in the year of the payment unless the taxpayer has rights against the borrower� The rights against the bor-rower become a bad debt in the year there is no longer any chance the borrower will repay the taxpayer�

Specific Charge-Off MethodUnder the specific charge-off method of deduct-ing business bad debts, the deduction cannot be claimed until the year the debt becomes partially or totally worthless. The taxpayer must claim the deduction within a time limit after the debt becomes partially or totally worthless.

Partly Worthless DebtTaxpayers cannot deduct a partially worthless business debt until they charge it off in their accounting records. They do not have to charge it off and claim the deduction in the year it becomes



Reporting a Business Bad DebtTaxpayers report business bad debts on the form or schedule where they report other business deductions, such as Schedule C (Form 1040), Profit or Loss From Business; Schedule F (Form 1040), Profit or Loss From Farming; Form 1065, U.S. Return of Partnership Income; or Form 1120, U.S. Corporation Income Tax Return. Employees report business bad debts as a miscel-laneous itemized deduction subject to the 2%-of-AGI floor on line 21 of Schedule A (Form 1040), Itemized Deductions, or line 7 of Schedule A (Form 1040NR), U.S. Nonresident Alien Income Tax Return. Example 16.19 illustrates reporting a bad-debt deduction in Part V of Schedule C (Form 1040).

Example 16.19 Business Bad Debt

When the balance on the loan from Emmanuel Miller was $75,000, Metal Fabricator, Inc. from Example 16.16 was insolvent because it did not receive the payment for the large order. Metal Fabricator’s bank repossessed all of its equipment, and it went out of business on June 20, 2016.

Emmanuel reports a bad-debt deduction on Schedule C (Form 1040), as shown in Figure 16.11.

Nonaccrual-Experience MethodTaxpayers who use an accrual method of account-ing can use the nonaccrual-experience method of reporting business bad debts if they

■■ provide services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, or the performing arts; or

■■ have average annual gross receipts of $5,000,000 or less for all prior years.

Under this method, taxpayers do not accrue service-related income they expect to be uncol-lectible. Because the expected uncollectible amounts are not included in income, these amounts are not later deducted as a business bad debt if they become worthless.

Taxpayers cannot use the nonaccrual-expe-rience method for amounts owed to them from activities such as lending money, selling goods, or acquiring receivables or other rights to receive payment.

Change in Method

Generally, the IRS must consent to a taxpayer’s change from one method to another� See Form 3115, Application for Change in Accounting Method, and its instructions for more informa-tion and exceptions�

FIGURE 16.11 Emmanuel Miller’s Schedule C (Form 1040)

16

20


Nonbusiness Bad Debts 561

16

Common Nonbusiness DebtsTransactions that commonly create nonbusiness debts include payments to clear liens on property, deposits, secondary liability on home mortgages, and loan guarantees (discussed later under “Rules for Both Business and Nonbusiness Bad Debts”).

Liens on PropertyWorkers, subcontractors, and material suppliers may file liens against property because of debts owed by a builder or contractor. A taxpayer who pays off the lien to avoid foreclosure and loss of the property is entitled to repayment from the builder or contractor. The taxpayer’s claim against the builder or contractor is a nonbusiness debt.

Example 16.22 Lien Payoff

Seth and Rachel Goldstein hired Nancy Peterson to be the general contractor for remodeling their home. Seth and Rachel paid Nancy for all of the work on their home, but Nancy did not pay sev-eral of the subcontractors who worked on their home. The subcontractors filed liens on Seth and Rachel’s home and began foreclosure proceed-ings to collect the amount owed to them. Seth and Rachel paid the subcontractors to avoid foreclo-sure on their property. Their claim against Nancy for repayment is a nonbusiness debt.

DepositsIf a taxpayer pays a deposit for goods or service unrelated to his or her trade or business, the tax-payer’s claim against the person or entity that holds the deposit is a nonbusiness debt.

Example 16.23 Deposit

Amanda Carpenter deposited $500 with Peter Jones on November 15, 2015, when she hired him to build a cabinet for her home. Peter declared bankruptcy on January 10, 2016. He did not build the cabinet and did not return the deposit. Amanda filed a claim in Peter’s bankruptcy case and received $100 on September 15, 2016. The remaining $400 is a nonbusiness debt.

Nonbusiness Bad Debts

Taxpayers can claim a short-term capital loss in the year a nonbusiness debt becomes totally worthless.

Definition of Nonbusiness DebtI.R.C. § 166(d)(2) defines nonbusiness debts as debts other than

■■ debts that were created or acquired in the taxpayer’s trade or business, or

■■ debts that were related to the taxpayer’s trade or business at the time they become worthless.

Business Debts

See the discussion of business debts earlier in this chapter for an explanation and examples of the business debts that are excluded from nonbusi-ness debts�

Taxpayers must show that the payment creat-ing the debt was intended as a loan rather than a gift. There must be a true debtor-creditor relation-ship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.

Example 16.20 Gift

Sarah Brown asked her parents to loan her $1,000 to pay her rent. Without any discussion of interest or repayment, her parents sent her $1,000.

Because there is no enforceable obligation for Sarah to repay the $1,000, it is a gift. Sarah’s par-ents cannot claim a nonbusiness loss if she does not repay the $1,000.

Example 16.21 Enforceable Loan

Hosea and Linda Cabrera loaned $50,000 to their son, Diego, for the down payment on his house. Diego signed a promissory note that requires him to pay principal and interest on the loan, and the loan is secured by a second mortgage on his home.

Diego’s obligation to pay Hosea and Linda is a nonbusiness debt.



credit or refund on an amended return by the later of



Reporting the LossTaxpayers deduct nonbusiness bad debts as short-term capital losses on Form 8949, Sales and Other Dispositions of Capital Assets, as illustrated in Example 16.25. They must attach a statement to their return that includes

1. a description of the debt, including the amount and the date it became due;

2. the name of the debtor, and any business or family relationship between the taxpayer and the debtor;

3. the efforts the taxpayer made to collect the debt; and

4. an explanation of why the debt was worth-less. (For example, the borrower declared bankruptcy, or legal action to collect would probably not result in payment of any part of the debt.)

Example 16.25 Reporting Nonbusiness Bad Debt

Amanda Carpenter from Example 16.23 reports her $400 nonbusiness loss as shown on Form 8949 in Figure 16.12 and attaches the statement shown in Figure 16.13 to her return.

Secondary Liability on Home MortgageTaxpayers may remain secondarily liable for repayment of the mortgage loan when a buyer of the mortgaged property assumes the mortgage. If the buyer defaults on the loan and the lender forecloses on the property and sells it for less than the amount outstanding on the mortgage, the tax-payer may have to make up the difference. The taxpayer’s claim against the buyer for paying the difference is a nonbusiness debt.

Limit on the LossThe nonbusiness bad-debt deduction is limited to the taxpayer’s basis in the debt. That means the taxpayer must have included the amount in income or loaned cash. Taxpayers generally can-not take a bad-debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.

Example 16.24 Unpaid Wages

Victoria Jorgensen worked for a flower shop that went bankrupt and did not pay her for two weeks of work. Victoria cannot claim a bad-debt deduction because she did not include the unpaid wages in income.

Timing of the LossUnlike a business bad debt, which can be deducted when it is partially worthless, a nonbusiness bad debt must be totally worthless to be deducted. In the year a debt becomes totally worthless, the tax-payer can deduct the entire amount, subject to the basis limit.

Taxpayers who did not deduct a nonbusiness bad debt on their original return for the year it became totally worthless can file a claim for a


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16

Worthless SecuritiesIf stock in a corporation or a bond or other evi-dence of indebtedness issued by a corporation or by a government becomes worthless during the tax year, the resulting loss is not treated as a bad debt. It is a loss from the sale or exchange of a capital asset on the last day of the tax year [I.R.C. § 165(g)].

Rules for Both Business and Nonbusiness Bad Debts

The rules for worthless securities, guarantees, proving a debt is worthless, and recovery of bad debts apply to both business and nonbusiness bad debts.

FIGURE 16.12 Amanda Carpenter’s Form 8949

FIGURE 16.13 Statement for Form 8949

Statement for line 1 of Form 8949Nonbusiness Bad Debt Deduction

1. Taxpayer deposited $500 with Peter Jones on November 31, 2015, as a down payment for a cabinet.

2. Peter Jones did not build the cabinet and did not return the deposit.3. Peter Jones declared bankruptcy on January 10, 2016.4. Taxpayer filed a claim in the bankruptcy proceeding and received $100 on September

15, 2016.



Favor to Friend Is a Gift

If a taxpayer guarantees a friend’s debt as a favor and does not receive any consideration in return, the taxpayer’s payments on the guaran-tee are considered a gift, and the taxpayer can-not deduct the payment as a bad debt�

Example 16.26 Business Loan Guarantee

In 2014, Amy Smith builds homes as a general contractor. Amy guaranteed a $30,000 loan to Pablo Sanchez, who is a painter that Amy relies on for advice and painting services for her cus-tomers. Pablo needed the loan to buy painting equipment to stay in business and could not get the loan without a third-party guarantee.

In 2016, Pablo was injured in an accident and could not work. As a result, he could not make the payments on the loan. Amy had to pay the bank $10,000 after it foreclosed on Pablo’s equip-ment and Pablo could not pay the remaining bal-ance of the debt.

Because Amy guaranteed the debt in the course of her business for a good-faith business purpose, her $10,000 claim against Pablo for the debt she paid for him is a business debt.

Example 16.27 Investment Loan Guarantee

Celine Dack, an officer and principal shareholder of the Sierra Corporation, guaranteed payment of a bank loan the corporation received. The cor-poration gave her a promissory note. The corpo-ration defaulted on the loan, and Celine made full payment. Because she guaranteed the loan to protect her investment in the corporation, Celine can deduct her payment as a nonbusiness bad debt. If instead she had guaranteed the loan to protect her compensation, it may be treated as a business bad debt.

Right of SubrogationA taxpayer’s payment on a loan he or she guaran-teed is a bad debt for the taxpayer in the year of the payment unless the taxpayer has the right to take the place of the lender (the right of subroga-tion) and collect the payment from the borrower.

Taxpayers who did not deduct a loss for a worthless security on their original return for the year it became worthless can file a claim for a credit or refund on an amended return by the later of



Loan GuaranteesA taxpayer’s payment of principal or interest that discharges the taxpayer’s obligation on a guar-antee of debt issued by another person creates a business or nonbusiness debt if the taxpayer

1. entered into the guarantee agreement in the course of the taxpayer’s trade or business or a transaction for profit,

2. entered into the guarantee agreement before the debt issued by the other person became worthless or partially worthless,

3. received reasonable consideration for making the guarantee, and

4. had a legally enforceable duty to make the payment on the debt issued by the other person.[Treas. Reg. § 1.166-9(d)]

A taxpayer is treated as entering into an agree-ment before the obligation became worthless (or partially worthless) if the taxpayer had a reason-able expectation at the time the agreement was entered into that he or she would not be called upon to pay the debt without full reimbursement from the debt issuer.

Reasonable consideration is not limited to direct consideration in the form of cash or prop-erty. If the taxpayer agreed to the guarantee with-out direct consideration in the form of cash or property but the taxpayer can demonstrate that the guarantee was in accordance with normal business practice or for a good-faith business pur-pose, the debt is business or nonbusiness debt. However, consideration received from a taxpay-er’s spouse or from a taxpayer’s qualifying child or qualifying relative for purposes of the I.R.C. § 152(a) definition of a dependent must be direct consideration in the form of cash or property.


Rules for Both Business and Nonbusiness Bad Debts 565

16

Recovery of a Bad DebtTaxpayers who recover part or all of a debt they deducted as a bad debt in an earlier year may have to include all or part of the recovery in gross income. The amount of the recovery included in income is limited to the amount of the bad-debt deduction. The recovery is not included in income to the extent it did not reduce the tax-payer’s income.

Taxpayers report the recovery of business bad debts as “Other income” on the appropri-ate business form or schedule. See IRS Publica-tion 525, Taxable and Nontaxable Income, for more information.

A bad-debt deduction that contributed to a net operating loss (NOL) reduces taxes in the year to which the taxpayer carries the NOL. Therefore, if a bad-debt deduction increases an NOL carryover that has not expired before the beginning of the tax year in which the recovery takes place, the bad-debt deduction is treated as having reduced the taxpayer’s tax.

Tax Benefit Rule

See the “Business Issues” chapter in this book for a discussion of the tax benefit rule and an exam-ple that illustrates to what extent a bad-debt recovery is included in income�

The right of subrogation becomes a bad debt in the year there is no longer any chance the bor-rower will repay the taxpayer.

No Interest or Loss DeductionPayments under a guarantee for the debt of another person or entity are not deductible as interest under I.R.C. § 163 or as a loss under I.R.C. § 165 [Treas. Reg. § 1.166-9(a) and (b)].

Proving Debt Is WorthlessA debt becomes worthless when there is no lon-ger any chance the amount owed will be paid. Taxpayers can claim a business bad-debt deduc-tion for part of a business debt in the year there is no longer any chance that part of the debt will be paid. Partial or total worthlessness may occur when the debt is due or prior to that date.

The IRS considers all pertinent evidence in determining whether a debt is partially or totally worthless, including the financial condition of the debtor and the value of any collateral that secures the debt.

To demonstrate worthlessness, taxpayers must show only that they took reasonable steps to collect the debt but were unable to do so. For example, if a taxpayer can show that a judgment from the court would be uncollectible, he or she does not have to sue the debtor to show the debt is worthless. Bankruptcy of the debtor is gener-ally good evidence of the worthlessness of at least a part of an unsecured debt.

Jointly Held Debt

If two or more debtors owe a taxpayer money, the debt is not worthless until there is no longer a chance any of the debtors will pay the debt� Inability to collect from one of the debtors does not allow the taxpayer to deduct a proportionate amount as a bad debt�


566 DEBT-RELATED INFORMATION RETURNS

Example 16.28 Lender Forecloses on Building

Don Broke has operated a surf shop in Locust, Missouri, as a sole proprietor for the last 5 years. He has been unable to make any principal pay-ments on the $100,000 recourse mortgage loan he took out to build a wave pool, but he did make the interest payments as they came due. On May 13, 2016, his lender, Big West Bank, foreclosed on the property, which was valued at only $75,000 at the time of the foreclosure.

Don received the Form 1099-A shown in Figure 16.14. After the foreclosure, he still owed Big West Bank $25,000, the difference between the $100,000 outstanding debt (box 2) and the property’s $75,000 fair market value (FMV) (box 4). Don must report the foreclosure as a sale or exchange on Form 4797, Sales of Busi-ness Property (Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2)). The sale price is the $75,000 FMV, and the date of sale is May 13. He has an I.R.C. § 1231 loss if his adjusted basis exceeds the $75,000 FMV, and a gain if the basis is less than the $75,000 FMV.

DEBT-RELATED INFORMATION RETURNS A lender who cancels debt or repossesses property must file an information return�

Taxpayers encountering financial distress fre-quently receive Form 1099-A, Acquisition or Abandonment of Secured Property; Form 1099-C, Cancellation of Debt; or both.

■■ Lenders who acquire an interest in secured property in partial or full satisfaction of the debt, or who have reason to know that the borrower has simply abandoned the secured property, must file Form 1099-A.

■■ Anyone in the trade or business of lending money or a federal government unit that cancels debt in excess of $600 must file Form 1099-C.

■■ If a debt is canceled in connection with a foreclosure or abandonment of secured property during the same year, the creditor may file only Form 1099-C, with the appro-priate entries in boxes 5 and 7.

FIGURE 16.14 Foreclosure on Building

2016


16

Debt-Related Information Returns 567

unless an I.R.C. § 108 exclusion provision applies. Don must report this income on line 21 (“Other income”) of his Form 1040, U.S. Indi-vidual Income Tax Return. If he can exclude the income, he must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082, Basis Adjustment), with his Form 1040.

Example 16.29 Discharge-of-Indebtedness Income

Don from Example 16.28 also had a separate $50,000 operating loan with Big West Bank, and later in 2016, Big West Bank decided to cancel that debt. The bank issued the Form 1099-C shown as Figure 16.15. Don has $50,000 of ordi-nary income from discharge of indebtedness,

Figure 16.15 Cancellation of Debt

Interest Not Included

The Form 1099-C issued to Don reflects only the principal owed on his operating loan� The bank does not have to include interest in box 2 because it would be a deduction for Don if he had paid it�

Example 16.30 Debt Canceled with Foreclosure

If Big West Bank from Example 16.28 deter-mined at the time it foreclosed on Don’s mortgage that it would not be able to collect the remaining $25,000 of the mortgage loan balance, the bank

could have canceled the balance at that time. In that case, the bank could choose to file only a Form 1099-C, as shown in Figure 16.16. Box 4 then includes a description of the property and the loan, and box 7 reports the FMV of the prop-erty as of the date of foreclosure. Don still reports the sale of property for $75,000 on Form 4797, and either reports the $25,000 of discharged debt as income on Form 1040 or as an exclusion from income on Form 982.

2016



5. A cancellation or extinguishment of an indebt-edness that renders a debt unenforceable pur-suant to a probate or similar proceeding

6. A discharge of indebtedness pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration

7. A discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discon-tinue collection activity and discharge debt

8. The expiration of a 36-month nonpayment testing period

36-Month Nonpayment PeriodTreas. Reg. § 1.6050P-1(b)(2)(iv) creates a rebut-table presumption that an identifiable event occurred at the end of a 36-month period if a creditor did not receive a payment on an indebt-edness during that period. The creditor may rebut the presumption if the creditor (or a third-party collection agency on behalf of the creditor) has engaged in significant, bona fide collection activity at any time during the 12-month period ending at the close of the calendar year, or if facts and circumstances existing as of January 31 of the calendar year following expiration of the 36-month period indicate that the indebtedness has not been discharged.

Events That Trigger a Form 1099-C Reporting Requirement

Current Treas. Reg. § 1.6050P-1(b)(2)(i) lists the following eight identifiable events that require any organization in the trade or business of lend-ing money to file Form 1099-C:

1. A discharge of indebtedness under the Bank-ruptcy Code

2. A cancellation or extinguishment of an indebtedness that renders the debt unen-forceable in a receivership, foreclosure, or similar proceeding in a federal or state court, as described in I.R.C. § 368(a)(3)(A)(ii), other than a discharge under the Bankruptcy Code

3. A cancellation or extinguishment of an indebtedness upon the expiration of the stat-ute of limitations for collection (but only if, and only when, the debtor’s statute-of-limi-tations affirmative defense has been upheld in a final judgment or decision in a judicial proceeding, and the period for appealing it has expired) or upon the expiration of a statu-tory period for filing a claim or commencing a deficiency judgment proceeding

4. A cancellation or extinguishment of an indebtedness pursuant to an election of fore-closure remedies by a creditor that statutorily extinguishes or bars the creditor’s right to pursue collection of the indebtedness

Figure 16.16 Foreclosure and Debt Cancellation

2016


Effect of Information Reporting on COD Income 569

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in question [S.C.A. 200235030 (June 3, 2002)]. While in most cases the debtor must include the amounts in income in the same year the credi-tor must report them, the years for reporting the income and for reporting the cancellation-of-debt (COD) income do not have to be the same. For example, a debtor’s payment of part or all of the liability in a year after the creditor reported it as discharged on Form 1099-C indicates the debt was not discharged and there was no COD income in the year the creditor files the Form 1099-C.

Statute of Limitations

In many cases, taxpayers argue that a triggering event (and therefore COD income) occurred in a year before the creditor issued Form 1099-C� Such taxpayers argue that because the statute of limitations has run for the earlier year, they never have to include the COD income� In Clark v. Com-missioner, T�C� Memo� 2015-175, the court agreed with the taxpayer that the debt was discharged in 2008 when the 36-month testing period ended, not in 2011 when the creditor filed Form 1099-C�

Filing Form 1099-AFiling Form 1099-A is only notification that a creditor acquired an interest in secured property in full or partial satisfaction of debt, or of the aban-donment of secured property. It is not meant to necessarily imply that the debtor received COD income [Corduan v. Commissioner, T.C. Summary Opinion 2001-74].

Burden of ProofThe IRS commissioner has no duty to investi-gate a third-party payment report (such as Form 1099-A or Form 1099-C) that is not disputed by the taxpayer [Parker v. Commissioner, 117 F.3d 785 (5th Cir. 1997)]. However, if the taxpayer reports a different amount on his or her tax return, a court will not presume a deficiency notice based on an information return is correct unless the IRS provides some indicia that the information return is correct [Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991)].

Proposed AmendmentThe Treasury Department and the IRS propose to remove the 36-month rule from the regulations because they think filing Form 1099-C should gen-erally coincide with the actual discharge of a debt. Because reporting under the 36-month rule may not reflect a discharge of indebtedness, a debtor may conclude that the debtor has taxable income even though the creditor has not discharged the debt and continues to pursue collection.

Issuing a Form 1099-C before a debt has been discharged may also cause the IRS to initiate com-pliance actions even though a discharge has not occurred. Additionally, Treas. Reg. § 1.6050P-1(e)(9) provides that no additional reporting is required if a subsequent identifiable event occurs. Therefore, in cases in which the Form 1099-C is issued because of the 36-month rule but before the debt is discharged, the IRS does not subse-quently receive third-party reporting when the debt is discharged.

The IRS’s ability to enforce collection of tax for discharge of indebtedness income may thus be diminished when the information reporting does not reflect an actual cancellation of indebt-edness. After considering the public comments and the effects on tax administration, the Trea-sury Department and the IRS propose to remove the 36-month rule.

Effect of Information Reporting on COD Income

Generally, income from discharge of indebted-ness must be taken into income when there is an“identifiable event” that shows the debt was dis-charged [Cozzi v. Commissioner, 88 T.C. 435, 445 (1987)]. When a debt has been canceled or dis-charged depends on the substance of the trans-action and is determined based on the facts and circumstances of each case.

Filing Form 1099-CThe eight triggering events under Treas. Reg. § 1.6050P-1(b)(2)(i) (discussed earlier) are for Form 1099-C reporting purposes only and do not automatically mean that the debtor must take the amounts reported into income in the year



including providing (within a reasonable period of time) access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the IRS [I.R.C. § 6201(d)]. The IRS then has the burden of producing reasonable and probative information in addition to the Form 1099-A or Form 1099-C.

If the IRS meets its burden and the court pre-sumes the deficiency notice is correct, the tax-payer can shift the burden of proof back to the IRS by asserting a reasonable dispute with respect to any item of income reported on Form 1099-A or Form 1099-C. To shift the burden of proof, the taxpayer must fully cooperate with the IRS,


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