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Dallas G. Thomsen, LL.M.
 

Insult to Injury: Discharge of Indebtedness Income

January 2010

Dallas G. Thomsen, LL.M.
503.243.1644

Published in The Daily Journal of Commerce, January 14, 2010

In these troubled times, businesses and individuals find themselves overloaded with debt as asset values and income levels decline.  In an effort to move forward, businesses and individuals use various methods including refinancing, workouts and short sales to restructure debt and relieve liability.  While the debt may be eliminated or reduced to a tolerable level, an additional, unplanned expense may be on the horizon:  income taxes resulting from discharge of indebtedness income.

The Internal Revenue Code ("IRC") requires taxpayers to include amounts from the discharge of indebtedness in gross income.  IRC § 61(a)(12).  Generally, a taxpayer may receive income from discharge of indebtedness when a debt or other liability is discharged, forgiven or otherwise reduced for no or inadequate consideration.  For example, if real property is sold for less than the balance owing on an existing mortgage and the difference is discharged (e.g. short sale), the transaction most likely will result in discharge of indebtedness income to the seller/borrower.  Additionally, nonjudicial foreclosures in which the remaining debt is discharged will in most circumstances result in discharge of indebtedness income. 

In most situations, the lender will provide a Form 1099 to the borrower which includes the amount of the discharge for tax reporting purposes.  Generally, the lender will "write-off" or deduct the amount discharged on its tax return, which will cause the Internal Revenue Service to look for a corresponding income item on the borrower's return.  A borrower may not receive a Form 1099 and should be aware of possible discharge of indebtedness issues any time a liability is discharged, forgiven or otherwise reduced (i.e., the fact that the borrower does nto receive a Form 1099 from the lender does not mean the borrower does not have discharge of indebtedness income).

Exceptions

If the taxpayer has discharge of indebtedness income, relief may be available.  Several statutory exceptions are available to taxpayers under IRC § 108 including bankruptcy, insolvency, qualified real property business indebtedness and qualified principal residence indebtedness.  In addition, exceptions have also arisen through case law.    

Bankruptcy

If the debt is discharged as a result of a bankruptcy, the taxpayer will have no discharge of indebtedness income.  IRC § 108(1)(A).  The bankruptcy case must, however, be filed under the jurisdiction of the federal bankruptcy court and the discharge of the debt must be granted by order of the bankruptcy court or pursuant to a bankruptcy plan approved by the bankruptcy court.

Insolvency

If the taxpayer is insolvent at the time of the discharge, the taxpayer will have no discharge of indebtedness income to the extent the taxpayer is insolvent.  IRC § 108(1)(B).  A taxpayer is insolvent if the taxpayer's liabilities exceed the taxpayer's assets.  However, this exclusion from reporting discharge of indebtedness income is limited to the amount the taxpayer is insolvent.  For example, if a taxpayer has $50,000 of assets and $100,000 of liabilities, the taxpayer is insolvent by $50,000.  If $75,000 of those liabilities are discharged and no other exceptions apply, $50,000 will be excluded from income, but $25,000 will be included in the taxpayer's taxable income as discharge of indebtedness income.

Qualified Real Property Business Indebtedness

If the discharge is attributable to qualified real property business indebtedness, the taxpayer will have no discharge of indebtedness income to the extent of the taxpayer's adjusted basis in the real property.  IRC § 108(1)(D).  Qualified real property business indebtedness is debt acquired or assumed in connection with real property used in a trade or business and secured by such real property.  If the debt was acquired or assumed on or after January 1, 1993, the debt must also be acquired or assumed in order to acquire, construct, reconstruct or substantially improve such property used in the business.  The property must be depreciable, so the exception may not be available to certain taxpayers such as real estate "dealers" where real property is treated as inventory. 

Qualified Principal Residence Indebtedness

If the debt was incurred to acquire the taxpayer's principal residence, then the taxpayer may not have discharge of indebtedness income.  IRC § 108(1)(E).  This exception was added in 2007 to help homeowners in a down market.  The qualified principal residence indebtedness exception is limited to $2,000,000 of debt ($1,000,000 for married individuals filing separately) and only applies to debt discharged before January 1, 2013. 

Guarantees

Discharge of indebtedness income applies only to primary obligations.  The discharge or release of guarantors does not give rise to discharge of indebtedness income due to the contingent nature of guaranties.  Landreth v. Com'r, 50 T.C. 803 (1968); Payne v. Com'r, T.C. Memo 1998-227.

In the current down economy, businesses and individuals are facing more and more situations where liabilities are forgiven or discharged.  Taxpayers need to be aware of potential tax liability due to discharge of indebtedness income.  Discharge of indebtedness income is a highly technical area and taxpayers should seek assistance from a tax competent professional if such a situation arises.


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