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2016 National Income Tax Workbook™
Financial Distress Pg 541 Cancellation-of-Debt 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 loan 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 debts $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 Bankruptcy Discharge while debtor in bankruptcy Insolvency 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 Interest 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 credit 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 Loans 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 accounting 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 Business loan guarantee Example 16.27 Investment loan guarantee
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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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