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2016 National Income Tax Workbook™

Financial Distress Pg 541  Cancellation-of- Income (CODI)

 Bad-Debt Deduction

 Debt-Related Information Returns

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Tax Attributes NIB  A tax attribute is one of a range of specific measures in the federal income tax calculation process that benefits the taxpayer.  It's relevant in cases when a taxpayer is insolvent or bankrupt.  The taxpayer must give up some or all of the benefit of tax attributes in return for receiving favorable treatment .

Financial Distress Income pg 542  Transactions triggering tax consequences: 1. Transfer of assets - recognition of gain or loss 2. Discharge of debt  Recognition of income or  Exclusion of income under §108 with reduction of tax attributes

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Recognition of Gain or Loss pg 542  Repossession, forced sale, voluntary sale  Example 16.1  Bank secured by stock  Bank sold the stock and applied to loan  Excess funds to Lotta  Lotta has gain – sales price less basis

Recognition of Gain or Loss pg 542  Repossession: Property Held for Sale  Cash basis: postpone income by delaying sale - Financial distress can accelerate  Example 16.2  Deduct crop costs 2016, to sell in 2017  Bank sells crop, 2016 income = FMV

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Recognition of Gain or Loss pp. 542-5  Repossession: Property Used in Business  Depreciation recapture – ordinary income  Example 16.3  § 1231 Gain or Loss  Sale at > original cost → § 1231 gain  Sale at < adjusted basis → § 1231 loss  Example 16.4  Example 16.5

Example 16.3 pg 543  TP purchased a sewing machine $5,000  Claimed depreciation over several yrs. $3,663  Basis $1,337  Sold to pay off $2,000  Realized gain $663  Reportable gain $663

 Sold for $900  Loss ($900 – 1,337 basis) (437)

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Inclusion of COD Income pg 543  CODI generally = difference between principal owed & amount accepted  Repossession: FMV = borrower payment  Example 16.6 Personal Use Asset  Truck - $23,000 with $20,000 loan  Repossessed: FMV = $12000, Loan = $15,000  COD income = $3,000 (15-12)  Loss of $11,000 (12-23) not deductible

COD Income – Special Rules p 544  Related party acquisition  Relative of debtor acquires debt for < FMV  Debtor has COD income (CODI)  Family = spouse, parents, children (+ spouses) grandchildren  + any related party under §§ 267(b) & 707(b)  Cancellation as gift → no CODI  Discharge w/o repossession → CODI

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Exceptions to COD Income p. 544   Discharge while debtor in bankruptcy   Liabilities exceed assets immediately before discharge of debt  Exception limited to insolvency amount  Principal Residence (2007-2016)  Qualified personal residence debt

Exceptions to COD Income p. 545  Deductible if paid  If taxpayer made payment, could deduct  Example 16.7  obligation for cash basis taxpayer

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Installment Purchase Pg 454

 Original seller → sale price adjustment  Buyer lowers basis by debt discharge  Not CODI to either party  Everyone is happy!!!

Exceptions to COD Income p. 545  Qualified farm debt  Debt owed to unrelated lender,  Incurred directly in T or B of farming, &  ≥ 50% taxpayer’s aggregate gross receipts for 3 years prior to discharge are from farming

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Exceptions to COD Income p. 545  Qualified Real Property Debt (N/A C corp)  Debt to acquire real property used in a T or B & secured by the real property (not held for sale)  Exclusion not to exceed: 1. Excess of outstanding debt principal just before over property FMV net of other debt it secures 2. Aggregate adjusted basis of depreciable property (after any basis reductions)

Exceptions to COD Income pp. 545-6  Grantor Trusts and Disregarded Entities  “Taxpayer” for bankruptcy and insolvency exclusions is the owner (not the entity)  § 108 exceptions apply in prescribed order  Practitioner Note, p. 546 (next slide)  Can elect to apply insolvency exception before qualified personal residence

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Ordering Rules for IRC 108 Pg 546

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

Election to Defer COD Income p.546  Election to defer CODI in 2009 and/or 2010  Defer the income until 2014 → recognize ratably over 5 year period  When deferred CODI recognized, § 108 exclusions will not apply

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Reduction in Tax Attributes p. 546

 Tax on CODI deferred by reduction in tax attributes  Reductions shown on Form 982  No reductions if qualifies for “deductible if paid” or installment purchase exception  Reduction rules differ for various exceptions

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Reduction in Tax Attributes p. 547

 Principal Residence: Reduce residence basis  Qualified Real Property Debt  Reduce basis in depreciable real property  Reduce at earlier of 1. End of the tax year of discharge 2. Immediately before property disposition  Bankruptcy, insolvency, qualified farm debt  7 attributes to reduce in prescribed order

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Reduction in Tax Attributes p. 547

1. NOL 2. General business 3. Minimum tax credit 4. Capital loss carryovers 5. Basis (may elect to apply first)  Limited to basis at beg’g of next year 6. PAL and passive credit carryovers 7. Foreign tax credit carryovers

Student pp. 547-548

 Debt cancelation tied to working a certain time period in certain professions not CODI if from 1. A government entity, 2. Certain tax-exempt public benefit corps, or 3. An educational institution  Education loan repayments not taxable if from:  NHSC Loan Repayment Program  State program eligible for funds under PHSA  State program for certain health services

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Attribute Reduction p. 551

 Tax attributes to zero, CODI remains  Bankruptcy or insolvency: No recognition  Qualified farm debt: Excess CODI taxable  Personal asset basis not reduced  Limit on Basis Reduction: Bankruptcy, Insolvency  Retain basis = debt remaining after discharge  No limit if elects to reduce depreciable first  (No limit - qualified farm debt basis reduction)

Example 16.8 pg 548  Operating loan $5,000,000 secured by building, equipment & other real estate (held for sale/inventory)  Bank forgives $1,000,000 (restructures debt)  TP assets FMV $3,500,000 & no other debt  Is TP insolvent under IRC 108?  TP has $5,600,000 in tax attributes  What attributes get reduced and in what order

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Example 16.8 pg 548  Debt cancelled $1,000,000  No election – NOL is reduced first - $400,000  Reduced to Zero/remaining $600,000  Building & land to zero - 150,000  Equipment to zero - 50,000  RE held for sale (pro rated) -400,000

 Remaining attribute balance 4,600,000

Election – Form 982 pg 550  Office building $60,000  Equipment 50,000  RE held for sale/allocate 890,000  Total attributes reduced $1,000,000

 TP saves his NOL to offset operating income $400,000

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CODI Exceeds Attributes pg 551  Bankruptcy – no problem – no attribution reduction  Insolvency – no problem – no attribution reduction  Qualified Farm Debt – limited to attributes  Excess is CODI (ordinary income)

Attribute Reduction pp 551-552

 Example 16.10 Insolvent  $75,000 aggregate basis in assets  $100,000 debt, $40,000 discharged  Basis reduction limit: $15,000 (75-60)  Still excludes full $40,000 for insolvency

 Rationale to limitation: To prevent tax if remaining assets sold for debt

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Attribute Reduction p. 553

 Order of Basis Reduction 1. Real property used in T or B or held for investment (not held for sale) that secured debt 2. Personal property used in T or B or held for investment (not inventory, receivables) that secured the debt 3. Remaining property (not inventory, real property held for sale, receivables)

Attribute Reduction p. 552

 Order of Basis Reduction 4. Inventory, notes receivables, accounts receivables, real property held for sale 5. Property not used in T or B and not held for investment  Example 16.11  Figure 16.6 Debt and Security – next slide  Figure 16.7 Assets

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Figure 16.7 Pg 553 Asset Basis FMV/Collateral Land & Building $100,000 $125,000/ $100K operating/ $500K Machine #1 $50,000 $20,000/ $30K Machine #2 $200,000 $60,000 Machine #3 $250,000 $35,000 Total $600,00 $240,000/ $630K

Attribute Reduction pp. 552-553

 Example 16.11 (continued)  $180,000 forgiven – No CODI recognition  Basis reduction: Lesser of $180,000 or $150,000 ($600,000 - $450,000)  Debt was secured by real property – reduce building and land by $100,000  Equipment also secured debt - $50,000 prorated among the machines (using basis)  Figure 16.8

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Attribute Reduction p. 553

 Qualified farm debt exception: Only property held for use in T or B (or for production of income) is reduced 1. Depreciable property 2. Land held for use in farming 3. Other qualified property  Basis reduction occurs at the end of the tax year of the discharge

Repayment of Cancelled Debt pg 533  Refund for tax paid in a prior year 1. Deduction in year repaid or 2. Reduction of income reported in earlier year

 Taxpayer must file amended return for year CODI was reported

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Qualified Personal Residence Debt (QPRI) p. 554  Example 16.13  Basis $250,000  Loan Balance $235,000 FMV $200,000  Plans to walkaway, let lender foreclose  Q1: Deductible loss?  Q2: Taxable COD income?  $35,000 debt discharge but may exclude as qualified principal residence indebtedness

QPRI – Example 16.13 pp 554-556

 Q3: Tax consequence to the exclusion?  $35,000 basis reduction (1-1-next year)  No other tax attribute affected – Figure 16.10

 Q4: What if prior home office deduction (including $2,500 depreciation)  Cannot treat as 2 properties, no loss deduction

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QPRI – Example 16.13 p. 556

 Q5: Does it matter if Jason is insolvent or files bankruptcy?  COD income still excluded  QPRI exclusion takes precedence unless Jason elects to apply insolvency exception  If in bankruptcy, cannot elect the QPRI exclusion in place of the bankruptcy exclusion

QPRI – Example 16.13 p.556

 Q6: What if gain on the deemed sale?  Could qualify for exclusion under § 121  Would he turn the house over if FMV > debt?  Q7: If loan restructured, $35,000 discharge in 2016, house sold in 2017 for $220,000?  Discharge is excluded, basis reduced to $215,000  Gain of $5,000 in 2017  If office depreciated, $2,500 not excludible

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Business Bad Debts - Definition p. 556 1. Debts created/acquired in the TP’s T or B or 2. Debts related to TP’s T or B when worthless

 Created or acquired in a business  Same idea as whether a loss is Tor B  Example 16.14  Sold business, retained 2014 rec’ble  2016 worthless, business debt

Business Bad Debts pp. 557-558

 Related to business when worthless  Use of funds not of consequence

 Ex. 16.14 sold receivable with business  New owner did not create/acquire in T or B but related to business when worthless  Q1 If sold debt to sister? Not business debt  Q2 If business inherited by son? Business debt

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Business Bad debts p. 558-559

 Common business debts  Loans to clients & suppliers  Debts of a partner  Loans to an employer  Loss = basis in the debt  Cash basis A/R → no basis  Accrual basis A/R → basis  Purchased A/R at < face → loss = cost

Business Bad Debt Timing p. 558

 Method determines timing of deduction  Specific Charge-Off Method  Deduct in year partially or totally worthless  Partially: if charge off in records  Amend: filing + 3 yrs or payment + 2 yrs  Totally: in year worthless net of earlier partial  Amend: filing + 7 yrs or payment + 2 yrs

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Business Bad Debt – Timing p.559

 Specific Charge-Off Method  Deduct in year partially or totally worthless  Partially: can deduct if charge off in accounting records  Totally: deduct in year worthless net of any earlier partial write-off

Business Bad Debt Timing p. 559

 Nonaccrual-Experience Method  Accrual taxpayers if  Provide services in specified fields  Average annual GR ≤ $5M all prior years  No accrual of service-related income expected to be uncollectible → no bad debt  Cannot use if for lending money, selling goods, acquiring receivables

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Business Bad Debt Reporting p. 560

 Deduct where income reported  Schedule C, Schedule F  Schedule A-2% if employee loan to employer  Example 16.19 – Business Bad Debt  Figure 16.11 – Sched C, Part V

Nonbusiness Bad Debt p. 560

 Not: 1. Debts created/acquired in TP’s T or B or 2. Debts related to T or B when worthless  Must show intended as loan, not gift  Establish true debtor/creditor relationship  Example 16.20 – Gift  Example 16.21 – Enforceable Loan

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Nonbusiness Bad Debts pg 561  Common nonbusiness bad debts  Lien on property – owner pays off lien, claim against contractor is nonbusiness debt  Example 16.22  Deposits for goods or services not in T or B  Example 16.23  Secondary liability on home mortgage  Buyer assumes mortgage & defaults

Nonbusiness Bad Debt Losses p. 562

 Loss = basis in debt  Example 16.24 – unpaid wages has no basis  Deducted only when totally worthless  Amend later of filing + 7 yrs or paym’t + 2 yrs  Short-term capital loss – Form 8949  Statement of specifics of debt, efforts to collect and explanation of why worthless  Example 16.25, Figure 16.12

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Other Bad Debt Rules p. 563-564  Worthless securities  Sale/exchange, capital asset, last day of year  Amend: later of filing + 7 yrs or paym’t + 2 yrs  Loan guarantees  Entered into as T or B or transaction for profit  Entered into before worthless at all  Reasonable consideration received  Legally enforceable

Other Bad Debt Rules p.564

 Loan guarantees  Reasonable expectation @ agreement that you would not have to pay w/o reimb. from debtor  Reasonable consideration not limited to cash or property  Guarantee: favor, no consideration – no debt  Example 16.26 guarantee  Example 16.27 Investment

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Other Bad Debt Rules p. 564-565

 Loan guarantees  No bad debt in year of payment if has right to replace lender and collect from debtor  No § 163 (interest) § 165 loss deductions  Proving debt worthless  Debtor(s) financial state, FMV of collateral  Took reasonable steps to collect  Bankruptcy of debtor good evidence

Other Bad Debt Rules p.565

 Recovery of a bad debt  Include all or part in gross income  Limited to amount of bad debt deduction that reduced taxable income  Report as “other income”  Bad debt in NOL still in carryover treated as having reduced taxable income

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Other Bad Debt Rules p. 566

 1099-A: Lender acquires interest in secured property in full/partial satisfaction of debt or know that property abandoned  1099-C: Anyone in T or B of lending or federal government unit canceling debt in excess of $600  1099-C only: Debt canceled w/foreclosure or abandonment during the year

Bad Debt Information Returns p. 566

 Example 16.28 Building Foreclosure  $100,000 loan, Property FMV $75,000  Report sale with $75,000 amount realized  Figure 16.14 – Form 1099-A (still owes $25K)  Example 16.29 $50,000 loan cancelled  Figure 16.15 – Form 1099-C  CODI of $50,000, Form 982 if exclusion  Interest not included – deductible if paid

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Bad Debt Information Returns p. 566 -568  Example 16.30  Bank realized $25,000 won’t be collectible  Canceled entire note @ foreclosure  Figure 16.16  Identifiable events triggering 1099-C  Treas. Reg. § 6050P-1(b)(2)(i)  List – page 568

Information Returns p. 559

 Identifiable events triggering 1099-C 1. Discharge in bankruptcy 2. Debt rendered unenforceable in a receivership, foreclosure or similar proceeding in court 3. Cancellation upon expiration of statute of limitations for collection (IRS?) 4. Cancellation by foreclosure election by creditor that bars rights to pursue collection

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Information Returns p. 568

 Identifiable events triggering 1099-C 5. Cancellation pursuant to probate or similar proceeding 6. Discharge by agreement for less than full consideration 7. Discharge by creditor based on creditor policy to discontinue collection & discharge debt 8. Expiration of 36-month nonpayment test period

Information Returns p. 569

 Expiration of 36-month nonpayment test period  Identifiable event if 36 months w/o payment  Can be rebutted with significant collection activity or facts at Jan 1 following show debt not discharged  Proposed regs remove 36-month rule in favor of 1099-C only for actual debt discharge

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Information Returns p. 569

 Form 1099-C not automatically = to CODI  Debt payment in next year shows debt not discharged yet  Triggering event might have been in prior year closed by statute  Form 1099-A not automatically = to CODI  Only notification creditor acquired interest in property or property abandoned

Information returns pp 569-570

 Notice of deficiency not presumed correct unless IRS has something to prove 1099 document is correct  If IRS meets burden, TP can dispute other items on 1099- A or C and shift burden back to IRS  TP must have fully cooperated with IRS  IRS has burden of producing proof in addition to 1099-A or C

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Questions?

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