11/3/2016 2016 National Income Tax Workbook™ Financial Distress Pg 541 Cancellation-of-Debt Income (CODI) Bad-Debt Deduction Debt-Related Information Returns 1 11/3/2016 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 2 11/3/2016 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 3 11/3/2016 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) 4 11/3/2016 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 5 11/3/2016 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 6 11/3/2016 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 7 11/3/2016 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 8 11/3/2016 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 9 11/3/2016 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 10 11/3/2016 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 11 11/3/2016 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 12 11/3/2016 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 13 11/3/2016 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 14 11/3/2016 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 15 11/3/2016 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 16 11/3/2016 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 17 11/3/2016 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 18 11/3/2016 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 19 11/3/2016 QPRI – Example 16.13 p.