An Introduction to the Tax Impact of Cancellation of Indebtedness Income Created by Loan Modification or Cancellation
By Richard M. Heller, Esquire
Law Office of Richard M. Heller
In today’s economy the commercial real estate market is experiencing a significant increase in the amount of distressed real estate. Most of this real estate is secured by mortgage debt, which cannot be repaid. As a result, the increase in mortgage restructuring, mortgage foreclosures, and abandonment of the property is creating an unintended tax consequence.
Those situations where there is a discharge of debt or debt being reduced through mortgage restructuring or debt forgiveness create cancellation of debt income. Such cancelled amounts may be classified as income for tax purposes. Normally when funds are borrowed it is not required that the loan proceeds be included in income because there is an obligation to repay the lender. However, if that obligation is subsequently forgiven the amount received as loan proceeds is thereafter reportable as income since there is no longer an obligation to repay the lender.
The lender thereafter would be required to report the amount of the cancelled debt to the borrower and to the Internal Revenue Service on a Form 1099C, Cancellation of Debt.
The general rule of Section 61(a)(12) of the Internal Revenue Code (“IRC”) provides that gross income includes income from the discharge of indebtedness.
Section 108 of the Internal Revenue Code provides statutory relief from recognition for debtors under certain circumstances and judicial exceptions which may be available to postpone or eliminate the recognition of such gain must also be taken into consideration, but the general rule of Section 1017 of the Internal Revenue Code (Discharge of Indebtedness) provides: “if an amount is excluded from gross income under Section 108 and any amount is to be applied to reduce basis, then such portion shall be applied in reduction of the basis of any property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs.”
In general under Section 108 gross income does not include any amount, which would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if (1) the discharge occurs in a Title 11 case, (2) if the discharge occurs when the taxpayer is insolvent, (3) if the indebtedness discharged is Qualified Farm Indebtedness or (4) in the case of the taxpayer other than a C Corporation, the indebtedness discharged is Qualified Real Property Business Indebtedness (Section 108(a)(1)(A)(B)(C)(D) of the IRC).
A discharge, which occurs in a Title 11 case, takes precedence over all other exclusions from gross income (Section 108(a)(2)(A) of the IRC). The insolvency exclusion takes precedence over the Qualified Farm Exclusion and the Qualified Real Property Business Exclusion (Section 108(a)(2)(B) of the IRC).
The Insolvency Exclusion is limited to amount of the insolvency in a case of a discharge which occurs because when the taxpayer is insolvent and the amount excluded should not exceed the amount by which the taxpayer is insolvent (Section 108(a)(3) of the IRC).
In general, the amount excluded from gross income shall be applied to reduce the tax
attributes of the taxpayer. The reduction of tax attributes is made in the following order (Section 108(b)(2) of the IRC):
The NOL is any net operating loss for the taxable year of the discharge, and any net operating loss carryover to such taxable year (Section 108(b)(2)(A) of the IRC).
The general business credit is any carryover to or from the taxable year of the discharge of an amount for purposes of determining the amount allowable as a credit under Section 38 (relating to general business credit) (Section 108(b)(2)(B) of the IRC).
The minimum tax credit is the amount of the minimum tax credit available under section 53(b) at the beginning of the taxable year immediately following the taxable year of the discharge (Section 108(2)(C) of the IRC).
The capital loss carryover is any net capital loss for the taxable year of the discharge, and any capital loss carryover to such taxable year under Section 1212 (Section 108(b)(2)(D) of the IRC).
The basis reduction of the property of the taxpayer is described in Section 1017 (Section 108(b)(2)(E) of the IRC) as any passive activity loss and credit carryover of the taxpayer under Section 469(b) from the taxable year of discharge (Section 108(b)(2)(F) of the IRC) and foreign tax credit carryovers are any carryover to or from the taxable year of the discharge for purpose of determining the amount of the credit allowable under Section 27 (Section 108(b)(2)(G) of the IRC).
The reductions shall be made after the determination of the tax imposed for the taxable year of the discharge (Section 108(b)(4)(A) of the IRC). Other reductions are made first in the loss for the taxpayer year of the discharge then in the carryovers to such taxpayer year in the order of the taxable years from which each such carryover arose (Section 108(b)(4)(B) of the IRC).
The taxpayer may first elect to apply any portion of the reduction under Section 1017 to the basis of the depreciable property of the taxpayer. However the amount to which an election applies shall not exceed the aggregate adjusted basis of the depreciable property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs (Section 108(b)(5) of the IRC).
The amount of discharge of Qualified Real Property Business Indebtedness excluded from gross income for a taxpayer other than a C Corporation shall be applied to reduce the basis of the depreciable real property of the taxpayer. See section 1017 for the description of the reduction (Section 108(c) of the IRC).
The amount of indebtedness in excess of the value excludable in the case of a taxpayer other than a C Corporation is applied to reduce the basis of the depreciable real property of the taxpayer. In the case of a taxpayer, other than a C Corporation, with respect to any Qualified Real Property Business Indebtedness shall not exceed the excess, if any, of (1) the outstanding principal amount of such indebtedness (immediately before the discharge) over (2) the fair market value of the real property reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property (as of such time) (Section 108(c)(2)).
The overall limitation is the amount excluded in the case of a taxpayer other than a C Corporation, which shall not exceed the aggregate adjusted basis of depreciable real property. Qualified Property Business Indebtedness is debt incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property. Further, “Qualified Acquisition Indebtedness” means, with respect to any real property, indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve such property (Section 108(c) of the IRC).
The term “indebtedness of taxpayer” means any indebtedness for which the taxpayer is liable, or subject to which the taxpayer holds property (Section 108(d)(1)(A)(B) of the IRC).
The term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, the amount by which the taxpayer is insolvent is determined on the bases of the taxpayer’s assets and liabilities immediately before the discharge. In the case of an S Corporation certain provisions shall be applied at the corporate level (Section 108(d)(7) of the IRC).
There is no insolvency exception, including discharges not in Title 11, from the general rule that gross income includes income from the discharge of indebtedness. No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction (Section 108(e) of the IRC).
The acquisition of outstanding indebtedness by a person bearing a relationship to the debtor (related parties) specified in Section 267(b) or 707(b)(1) from a person that does not bear such a relationship to the debtor shall be treated as the acquisition of such indebtedness by the debtor. The members of a family of an individual consist of an individual’s spouse, grandchildren and parents, and any spouse of the individual’s children or grandchildren. Entities under common control are treated as a single employer shall be treated as a related party (Section 108(e)(4) of the IRC).
A Purchase-Money debt reduction for a solvent debtor is treated as a price reduction:
(1) if the debt of a purchaser of the property to the seller of such property arose out of the purchase of such property and such reduction does not occur in a Title 11 case or (2) when the purchaser is insolvent and such reduction would be treated as income to the purchaser from the discharge of indebtedness (Section 108 (e)(5) of the IRC).
If a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, then such corporation shall be treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness (Section 108(e)(6) of the IRC).
A creditor may acquire stock of a debtor corporation in satisfaction of such corporation’s indebtedness and such stock is treated as section 1245 property (Section 108(e)(7) of the IRC).
When a debtor issues a debt instrument in satisfaction of indebtedness, such debtor shall be treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument (Section 108(e)(10) of the IRC).
Discharge of Qualified Farm Indebtedness shall apply only if the discharge is by a qualified person. Indebtedness of a taxpayer shall be treated as Qualified Farm Indebtedness if (1) such indebtedness was incurred directly in connection with the operation by the taxpayer of the trade or business of farming and (2) 50 percent or more of the aggregate gross receipts of the taxpayer for the 3 taxable years preceding the taxable year in which the discharge of such indebtedness occurs is attributable to the trade or business of farming (Section 108(g) of the IRC).
The amount of Qualified Farm Indebtedness excluded shall not exceed the sum of the adjusted tax attributes of the taxpayer and the aggregate adjusted basis of qualified property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs (Section 108(g) of the IRC).
At the election of the taxpayer, income from the discharge of Business Indebtedness in connection with the reacquisition (after December 31, 2008, and before January 1, 2011), of an applicable debt instrument shall be includible in gross income ratably over five (5) taxable years. If as part of a reacquisition any debt instrument is issued for the applicable debt instrument being reacquired and there is any original issue discount, the aggregate amount of deductions disallowed shall be allowed as a deduction ratably and deferred over a 5-taxable year period (Section 108(i)(2) of the IRC).
If any debt instrument is issued by an issuer and the proceeds of such debt instrument are used directly or indirectly by the issuer to reacquire an applicable debt instrument of the issuer, the debt instrument so issued shall be treated as issued for the debt instrument being reacquired.
In conclusion, Section 108 of the Internal Revenue Code provides the guidance for the treatment of Cancellation of Debt Income. The Secretary of Treasury has the authority to promulgate the applicable rules and regulations to interpret the various subsections of Section 108. This guidance applies to individuals, partnerships and both “S” and “C” Corporations. Court decisions and Judicial interpretations further define this important area of the tax law.