Procedural Requirements for Imposition of Penalties and Additions to Tax
The Internal Revenue Service Restructuring Act required that each notice imposing a penalty include the name of the penalty, the Code section imposing the penalty, and a computation of the penalty. The Act also requires the specific approval of IRS management to assess all non computer generated penalties unless excepted. This provision does not apply to failure to file penalties, failure to pay penalties, or to penalties for failure to pay estimated tax.
Cancellation of Debt-Foreclosures
By: Robert E. McKenzie ©2011
1. DEBT CANCELLATION
1.10 If a debt is canceled or forgiven, other than as a gift or bequest, the debtor generally must include the canceled amount in gross income for tax purposes. A debt includes any indebtedness for which the debtor is liable or which attaches to property the debtor holds.
Exceptions and exclusions
1.20 There are several exceptions and exclusions from the inclusion of canceled debt in income. The exceptions and exclusions include:
1 The cancellation of a student loan for a student required to work for certain employers,
2 The cancellation of debt that would have been deductible if paid.
3 The reduction of a debt by the seller of property if the debt arose from the purchase of the property.
4 The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.
5 The cancellation takes place when taxpayers are insolvent (see insolvency exclusion, later), and the amount excluded is not more than the amount by which taxpayers are insolvent.
6 The canceled debt is qualified farm debt (debt incurred in operating a farm).
7 The canceled debt is qualified real property business indebtedness (certain debt connected with business real property).
8 The canceled debt is acquisition indebtedness on a principal residence. See Mortgage Forgiveness Debt Relief Act of 2007 (HR 3648).
9 Reacquisition of business debt. The American Recovery and Reinvestment Act of 2009 allowed certain businesses to elect to defer and include ratably over 5 tax years any income from the cancellation of debt arising from the reacquisition of certain types of business debt repurchased in 2009 and 2010. If you made the election, you cannot exclude for the taxable year of the election or any subsequent year the income from the cancellation of such indebtedness based upon a title 11 bankruptcy case, insolvency or qualified farm indebtedness or qualified real estate indebtedness.
Order of exclusions
1.30 If the cancellation of debt occurs in a title 11 bankruptcy case, the bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, or qualified real property business indebtedness exclusions.
To the extent that the taxpayer is insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions.
Bankruptcy case exclusion
1.40 A bankruptcy case is a case under title 11 of the United Sates Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
None of the debt canceled in a bankruptcy case is included in taxpayer’s gross income in the year canceled. Instead, certain losses, credits, and basis of property must be reduced by the amount of excluded income (but not below zero). These losses, credits, and basis in property are called tax attributes and are discussed under Reduction of Tax Attributes, later.
1.50 Taxpayers are insolvent when, and to the extent, taxpayer’s liabilities exceed the fair market value of taxpayer’s assets. Determine taxpayer’s liabilities and the fair market value of taxpayer’s assets immediately before the cancellation of taxpayer’s debt to determine whether or not taxpayers are insolvent and the amount by which taxpayers are insolvent.
Exclude from taxpayer’s gross income debt canceled when taxpayers are insolvent, but only up to the amount by which taxpayers are insolvent. However, taxpayers must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.
Example: $4,000 of the Simpson Corporation’s liabilities are cancelled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation’s liabilities totaled $21,000 and the fair market value of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 – $17,500).
The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.
Reduction of tax attributes.
1.60 If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain “tax attributes.” Tax attributes include the basis of certain assets and the losses and credits listed next. By reducing these tax attributes, tax on the canceled debt is in part postponed instead of being entirely forgiven. This presents an excessive tax benefit from the debt cancellation. If a separate bankruptcy estate was created, the trustee or debtor-in-possession must reduce the estate’s attributes (but not below zero) by the canceled debt. See Individuals under chapter 7 or chapter 11, later.
Order of reduction
1.70 Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below. However, taxpayers may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. This choice is discussed later.
Net operating loss First, reduce any net operating loss for the tax year in which the debt cancellation takes place, and any net operating loss carryover to that tax year.
General business credit carryover Second, reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit.
Minimum tax credit Third, reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation.
Capital losses Fourth, reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.
Basis Fifth, reduce the basis of taxpayer’s property as described under Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property.
Passive activity loss and credit carryovers Sixth, reduce any passive activity loss or credit carryover from the tax year of the debt cancellation.
Foreign tax credit Last, reduce any carryover, to or from the tax year of the debt cancellation, of an amount used to determine the foreign tax credit or the Puerto Rico and possession tax credit.
Amount of reduction
1.80 Except for the credit carryovers, reduce the tax attributes listed earlier one dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 33-l/3 cents for each dollar of canceled debt that is excluded from income.
Making the reduction
1.90 Take the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing net operating losses and capital losses, first reduce the loss for the tax year of the debt cancellation, and then any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. Make the reductions of credit carryovers in the order in which the carryovers are taken into account for the tax year of the debt cancellation.
Individuals under chapter 7 or chapter 11
1.100 In an individual bankruptcy under chapter 7 (liquidation) or chapter 11 (reorganization) of title 11, the required reduction of tax attributes must be made to the attributes of the bankruptcy estate, a separate taxable entity resulting from the filing of the case. Also, the trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes. See the discussion of The Bankruptcy Estate, earlier.
1.110 If any amount of the debt cancellation is used to reduce the basis of assets as discussed under Reduction of Tax Attributes, the following rules apply to the extent indicated.
When to make the basis reduction
1.120 Make the reduction in basis at the beginning of the tax year following the tax year of the debt cancellation. The reduction applies to property held at that time. See section 1.1017-1 of the Income Tax Regulations for more information.
Bankruptcy and insolvency reduction limit.
1.130 The reduction in basis because of canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later.
Exempt property under title 11.
1.140 If debt is canceled in a bankruptcy case under title 11 of the United States Code, make no reduction in basis for property that the debtor treats as exempt property under section 522 of title 11.
Election to reduce basis first
1.150 Taxpayers (the estate in the case of an individual bankruptcy under chapter 7 or 11) may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.
Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. Taxpayers may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. Taxpayers must generally make this choice on the tax return for the tax year f the debt cancellation, and once made, taxpayers can only revoke it with IRS approval. However, if taxpayers establish reasonable cause, taxpayers may make the choice with an amended return or claim for refund or credit.
1.160 Make the election to reduce the basis of depreciable property before reducing other tax attributes as well as the election to treat real property inventory as depreciable property, on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
Recapture of basis reductions.
1.170 If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain that is from this basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of this basis reduction as a depreciation deduction and by treating any such basis reduced property that is not already either section 1245 or section 1250 property as section 1245 property. In the case of section 125 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation.
1.180 If a partnership’s debt is canceled because of bankruptcy or insolvency, the rules for the exclusion of the canceled amount from gross income and for tax attribute reduction are applied at the individual partner level. Thus, each partner’s share of debt cancellation income must be reported on the partner’s return unless the partner meets the bankruptcy or insolvency exclusions explained earlier. Then all choices, such as the choices to reduce the basis of depreciable property before reducing other tax attributes, to treat real property inventory as depreciable property, and to end the tax year on the day before filing the bankruptcy case, must be made by the individual partners, not the partnership.
1.190 For purposes of reducing the basis of depreciable property in attribute reduction, a partner treats is or her partnership interest as depreciable property to the extent of the partner’s proportionate interest in the partnership’s depreciable property. This applies only if the partnership makes a corresponding reduction in the partnership’s basis in its depreciable property with respect to the partner.
Partner’s basis in partnership
1.200 The allocation of an amount of debt cancellation income to a partner results in that partner’s basis in the partnership being increased by that amount. At the same time, the reduction in the partner’s share of partnership liabilities caused by the debt cancellation results in a deemed distribution, in turn resulting in a reduction of the partner’s basis in the partnership. These basis adjustments are separate from any basis reduction under the attribute-reduction rules described earlier.
1.210 Corporations in a bankruptcy proceeding or insolvency generally follow the same rules for debt cancellation and reduction of tax attributes as an individual or individual bankruptcy estate would follow.
Stock for debt exchange
1.220 If a corporation transfers its stock in satisfaction of indebtedness and the fair market value of its stock is less than the indebtedness it owes, the corporation has income (to the extent of the difference) from the cancellation of indebtedness. After 1994, a corporation can exclude all or a portion of the income created by the stock for debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent. However, the corporation must reduce its tax attributes (to the extent it has any) by the amount of excluded income.
Stock for debt exception
1.230 The stock for debt exception was repealed for transfers made after 1994 unless the corporation filed for bankruptcy (or similar court proceeding) before 1994. Generally, before 1995, a corporation did not realize income because of such stock for debt exchanges if it was in bankruptcy or to the extent it was insolvent. Consequently, there was no gross income to exclude and no reduction of its tax attributes was necessary. The principal difference between the stock for debt exception and the stock for debt exchange is that the corporation does not reduce its tax attributes under the stock for debt exception.
Earnings and profits
1.240 The earnings and profits of a corporation do not include income from the discharge of indebtedness to the extent of the amount applied to reduce the basis of the corporation’s property as explained earlier. Otherwise, discharge of indebtedness income, including amounts excluded from gross income, increases the earnings and profits of the corporation (or reduces a deficit in earnings and profits).
If there is a deficit in the corporation’s earnings and profits and the interest of any shareholder of the corporation is terminated or extinguished in a title 11 or similar case (defined earlier), the deficit must be reduced by an amount equal to the paid-in capital allocable to the shareholder’s terminated or extinguished interest.
1.250 For S corporations, the rules for excluding income from debt cancellation because of bankruptcy or insolvency apply at the corporate level.
Net operating losses.
1.260 A loss or deduction that is disallowed for the tax year of the debt cancellation because it exceeds the shareholders’ basis in the corporation’s stock and debt is treated as a net operating loss for that tax year in making the required reduction of tax attributes for the amount of the canceled debt.
Tax attribute reduction example.
1.270 The sample filled-in Form 982, Reduction in Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), shown in this publication is based on the following situation.
Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 1995, he reached an agreement with his creditors, whereby they agreed to forgive $10,000 of the total that he owed them, in return for his setting up a schedule for repayment of the rest of his debts.
Immediately before the debt cancellation, Tom’s liabilities totaled $120,000 and the fair market value of his assets was $100,000 (his total basis in all these assets was $90,000). At the time of the debt cancellation, he was considered insolvent by $20,000. He can exclude from income the entire $10,000 debt cancellation because it was not more than the amount by which he was insolvent.
Among Tom’s assets, the only depreciable asset is a rental condominium with an adjusted basis of $50,000. Of this, $10,000 is allocable to the land, leaving a depreciable basis of $40,000. He has a long-term capital loss carryover to 1996 of $5,000. He also has a net operating loss of $2,000 and a $3,000 net operating loss carryover from 1994. He has no other tax attributes arising from the current tax year or carried to this year.
Ordinarily, in applying the $10,000 debt cancellation amount to reduce tax attributes, Tom would first reduce his $2,000 net operating loss, next his $3,000 net operating loss carryover from 1994, and then his $5,000 net capital loss carryover. However, he figures that it is better for him to preserve his loss carryovers for the next tax year.
Tom elects to reduce basis first. He can reduce the depreciable basis of his rental condominium (his only depreciable asset) by $10,000. The tax effect of doing this will be to reduce his depreciation deductions for years following the year of the debt cancellation. However, if he later sells the condominium at a gain, the part of the gain from the basis reduction will be taxable as ordinary income.
Tom must file Form 982, as shown here, with his individual return (Form 1040) for the tax year of the debt discharge. In addition, he must attach a statement describing the debt cancellation transaction and identifying the property to which the basis reduction applies. This statement is not illustrated.
Tax Consequences to Mortgagor; Foreclosure Sale; Mortgagor Personally Liable
2.10 A sale of mortgaged property to a third party pursuant to a foreclosure is treated, for federal income tax purposes, as a sale or exchange of the property. [EN1] Gain or loss is measured by the difference between the mortgagor’s basis in the property and the amount realized. In the event that the mortgage balance is less than the sale proceeds, the amount realized is the amount of the sale proceeds. If the mortgage balance exceeds the sale proceeds and the mortgagor is discharged from liability for the excess under the mortgage, the amount realized is the mortgage balance, and the excess is cancellation of indebtedness income. [EN2] If the mortgage balance exceeds the sale proceeds, but the mortgagor is not discharged from liability for the excess, the amount realized is the amount of the foreclosure sale proceeds. [EN3]
Example (1): Assume X purchased nondepreciable real property for $100,000 paying $20,000 cash and securing a mortgage loan of $80,000. When the mortgage has been reduced to $72,000, X defaults and the property is sold at foreclosure for $82,000. X has a capital loss of $18,000.
Example (2): Assume the same facts as in Example (1) except that the property is sold at foreclosure for $68,000. The mortgagee commences proceedings against X to collect the deficiency of $4,000. X has a capital loss of
$32,000. X’s eventual payment of the mortgage deficiency does not affect this result since the entire amount of the mortgage debt (including the $4,000) was reflected in X’s basis in the property.
Example (3): Assume the same facts as in Example (2) except that the mortgagee discharges X from liability for the excess under the mortgage. X has a capital loss of $28,000, and cancellation of indebtedness income of $4,000.
Section 1231 – Property
2.20 The tax results can change if the mortgaged property is Section 1231(b) property rather than a capital asset. If that is the case, the indicated losses (depending on the results of other transactions in Section 1231(b) property during the year of foreclosure) could be ordinary rather than capital. If the property was depreciated, the results would be further altered.
Example (1): Assume X purchased depreciable real property for $100,000, paying $20,000 cash and securing a mortgage of $80,000. When the mortgage has been reduced to $72,000 and the property’s basis has been depreciated to $70,000 (straight line depreciation), X defaults and the property is sold at foreclosure for $82,000. X has Section 1231 gain of $12,000.
Example (2): Assume the same facts as in Example (1) except that the property is sold at foreclosure for $68,000. The mortgagee commences proceedings against X to collect the deficiency of $4,000. X has a Section 1231 loss of $2,000.
Example (3): Assume the same facts as in Example (2) except that the mortgagee fails to perfect his rights against X. X has a Section 1231 loss of $2,000 and cancellation of indebtedness income of $4,000, or if the debt is qualified real property business debt and if the mortgagee elects under Section 108(c) (discussed at VIII, G, 1, c, (2), below), Section 1231 gain of $2,000.
Unpaid interest and taxes
2.30 To the extent that the proceeds of the foreclosure sale, rather than being paid to the mortgagee, are used to discharge interest arrearages and real property taxes of the mortgagor, such items should be deductible to the mortgagor. [EN4] Interest paid would presumably take the character of the property foreclosed upon under Regs. Section 1.163-8T. If the property were rental property, the interest paid should be classified as passive. If incurred in connection with the disposition of the property it should be deductible in full if the property were the taxpayer’s only rental activity or if the taxpayer’s real estate activity is considered a separate activity under the passive loss rules.
Timing of recognition of gain or loss
2.40 A mortgagor realizes taxable gain or loss in the year that the foreclosure sale becomes final. In states which provide for a right of redemption in the mortgagor, the sale remains “open” until the redemption period expires. [EN5] Thus, a mortgagor (in a jurisdiction which provides for a right of redemption) who wishes to fix his loss in the year of the foreclosure sale may do so by releasing his right of redemption to the purchaser. [EN6] If the right of redemption is itself worthless and is abandoned, then a loss in the earlier year could be claimed. However, as with all issues of “worthlessness,” the absence of an identifiable event may result in a failure of proof. In the event a foreclosure is contested, it appears that the appropriate year for recognition is the year the decision is final. [EN7]
Exercise of right of redemption.
2.50 If the mortgagor redeems property before the period provided for exercising his right of redemption expires, then no loss is allowable. [EN8]
Foreclosure Sale — Mortgagor without personal liability
2.60 In the event of a foreclosure sale of mortgaged property as to which the mortgagor is not personally liable, the mortgagor is considered to have sold the property. [EN9] The amount realized on the sale had been thought to include the full amount of the mortgage debt. [EN10] However, in Tufts v. Comr., [EN11] the Fifth Circuit held that a nonrecourse mortgagor could realize, on foreclosure, no more than the fair market value of the property where the fair market value of the property was less than the mortgage. The Supreme Court overruled the Fifth Circuit. [EN12] In so doing, it directly addressed the uncertainty that had been generated by the infamous footnote 37 of Crane. As indicated previously, Crane established the symmetry in the treatment of liabilities for purposes of determining both basis and amount realized. Footnote 37 of the Crane decision suggested that a different answer might be required on the realization side of the equation where the value of the property was less than the outstanding mortgage.
Fair market value irrelevant
2.70 The Supreme Court in Tufts addressed the footnote 37 issue directly and concluded that fair market value was irrelevant to the issue of realization, reasoning that the mortgagor had initially received the sums tax free and had included them in the basis of the property on the understanding that he had an obligation to pay the sums back. When the obligation is cancelled, the mortgagor is relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent within the meaning of Section 1001(b). The Supreme Court also noted that the result that it reached also ended the absurd result of allowing a deduction (by way of reduction in the amount realized to reflect the decline in the value of the property to less than the mortgage) to the person who did not suffer the loss.
Accrued unpaid interest
2.80 What happens to accrued but unpaid interest when the property is foreclosed upon? In Allan v. Comr., [EN13] the Tax Court considered a situation involving an accrual basis taxpayer and nonrecourse mortgage debt. The mortgage was insured under Section 221(d)(4) of the National Housing Act. After approximately three years, the mortgage went into default, the original mortgagee exercised its rights against HUD to collect the unpaid balance, and HUD acquired the mortgage. During the four years between the time HUD acquired the mortgage and the time that HUD foreclosed, HUD charged the partnership for interest. The partnership continued to accrue and deduct such interest. At the time of the foreclosure, the value of the property was less than the principal amount of the debt and the accrued but unpaid interest.
2.90 Upon the foreclosure, the IRS argued that the tax benefit rule required previously deducted but unpaid interest to be “recaptured” as ordinary income to the extent it had previously resulted in a tax benefit. As applied to the facts, this was consistent with its prior position expressed in PLR 8041017 that the amount realized will not include interest to the extent that the fair market value of the property does not equal or exceed the principal amount plus such interest because, in Allan, the value of the property was less than the principal amount of the debt. However, the IRS went further by asserting that the amount realized was limited to liabilities included in basis, a position it had not previously advanced and one inconsistent with PLRs 8041017 and 8041019.
Taxpayer allowed to deduct interest
2.100 The Tax Court refused to classify Allan as a “tax benefit” case even though the fair market value was less than the principal amount of the debt; rather, the court viewed the interest payments as having been “borrowed” by the partnership and paid to HUD. As a result, the amount of the interest, or new borrowing, was added to principal, and the Tax Court considered it an “amount realized” on foreclosure under Tufts. So viewed, the fact that the taxpayer “used” the proceeds of the debt to pay deductible expenses did not affect the result. The Tax Court did not regard as relevant the fact that the portion of the principal balance which represented interest was not included in basis, relying instead upon the Supreme Court’s statement that:
“Our analysis applies even in the situation in which no deductions are taken. It focuses on the obligation to repay and its subsequent extinguishment, not on the taking and recovery of deductions.” [EN14]
Accrual nonrecourse mortgage – recapture interest
2.110 If the interest on nonrecourse mortgage debt of an accrual basis mortgagee is not added to principal and therefore is not an “amount realized,” it would appear that the tax consequences would depend upon whether the fair market value of the property is sufficient to discharge the principal and interest. If the fair market value is sufficient, then the interest should be considered to have then been “paid” and no “recapture” of previously claimed interest deductions would be appropriate. If, however, the value of the property is less than the principal balance and accrued but previously deducted interest, then it would appear that the “tax benefit” rule should apply and the previously deducted interest, to the extent it previously resulted in a tax benefit, should be included in income. [EN15] The end result should be no different than in the case of the cash basis mortgagor discussed below. If a cash basis mortgagor is not entitled to a deduction, an accrual basis mortgagor should be required to “recapture” previously taken deductions which will not be paid. The method of accounting should not dictate whether an amount is ultimately deductible or includible in income.
Cash basis nonrecourse – no interest deduction
2.120 A cash basis mortgagor has a situation which is a little bit different. The issue for a cash basis mortgagor is whether, in a foreclosure of a nonrecourse mortgage, he can be considered to have paid accrued but unpaid interest and therefore be entitled to a deduction at the time of the foreclosure. Given a cash basis taxpayer in the situation which obtained in Allan, it appears that no deduction would have been allowable because the value of the property was less than the principal amount of the debt. It would appear, however, that when the value of the property exceeds the principal amount of the debt, interest should be considered as paid to that extent and a deduction should be allowed.
2.130 As a general rule, partial payments in satisfaction of indebtedness are applied first to interest and then to principal. [EN16] Thus, one would think that a cash basis mortgagor who suffers through a foreclosure which yields an amount less than the outstanding principal and interest would nevertheless be entitled to have the proceeds applied first to interest, so as to generate a deduction, and then to principal. Likewise, an accrual basis taxpayer should, if the general rule applied, be entitled to apply the value of the property or bid price first against accrued interest so as to avoid the tax benefit rule.
Exception to general rule
2.140 The general rule does not apply, however, to a foreclosure where the evidence suggests that the mortgagor is insolvent at the time of the foreclosure. [EN17] The rationale for the holding is set forth in Newhouse as follows:
“… it [is] difficult to believe that a creditor who has foreclosed on the collateral of an insolvent debtor, and who will never get back the full amount of his principal, is required to report a fictitious amount of income designated as interest.”
Deduction allowed to Mortgagor when it is income to Mortgagee.
2.150 This symmetry, as required by the tax law, suggests that a deduction will be allowed to the mortgagor only if the mortgagee is required to recognize income. The exception will not apply, and the general rule will prevail, where the mortgagor is solvent and the debt is not discharged. Clearly, in the context of nonrecourse debt, the general rule (interest first) would be inapplicable. Observation: A recourse mortgagor who is insolvent will generally fare better than a nonrecourse mortgagor when the value of the property is less than the debt. Allan may have narrowed the gap somewhat, characterizing unpaid interest as part of the amount realized upon the foreclosure of nonrecourse debt rather than an amount subject to “recapture” under the tax benefit rule. Nevertheless, insolvent nonrecourse mortgagors might consider converting their mortgage debt to recourse debt (provided, of course, that they are assured of being discharged) to make the most of a bad situation.
Conveyance to Mortgagee — Mortgagor With Personal Liability
2.160 The voluntary conveyance of mortgaged property by the mortgagor to a nonvendor mortgagee, or a deed in lieu of foreclosure, which extinguishes the debt, is treated as a taxable sale by the mortgagor. [EN18] If, however, the fair market value of the property is less than the outstanding mortgage, then the transaction is bifurcated into an exchange (with amount realized being the fair market value of the property) and cancellation of indebtedness (to the extent the mortgage is in excess of fair market value). [EN19]. Taxpayers other than C corporations may elect to exclude income from the discharge of qualified real property business debt from gross income. [EN20]
Qualified real property business debt generally is debt:
1. that the taxpayer incurred or assumed in connection with real property used in a trade or business and is secured by that real property, and
2. that was incurred or assumed before 1993, or is “qualified acquisition indebtedness.” [EN21]
2.170 The amount of discharged indebtedness excluded may not exceed the excess of
1. the outstanding principal amount of the debt just before the discharge, over
2. the fair market value of the business real property that is security for the debt. The amount excluded also may not exceed the basis of the taxpayer’s depreciable real property, and reduces the basis of the property. [EN22]
Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”)
2.180 This act’s purpose is to address the hardship where a taxpayer loses her home in foreclosure and also receives a tax bill from the IRS for cancellation of debt income. The Act added a new § 108 exclusion to cancellation of debt income. This exclusion is only applicable for discharges of indebtedness that occurs during 2007 though 2012, and only applies to a qualified principal residence.
A qualified principal residence means acquisition indebtedness under § 163(h)(3)(B), except that the dollar limit is $2 millions. The limit is $1 million for a married person filing a separate return.
The debt must have been used to buy, build, or substantially improve the taxpayer’s principal residence and must have been secured by that residence. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.
Borrowers whose debt is reduced or eliminated receive a year-end statement (Form 1099-C) from their lender. For debt cancelled in 2007, the lender was required to provide this form to the borrower by January 31, 2008. By law, this form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure. In order to claim this special tax relief, the taxpayer must fill out the newly-revised Form 982 and attach it to the tax return.
The exclusion does not apply to a taxpayer in a Title 11 bankruptcy case; instead the present-law exclusion at § 108(a)(1)(A) applies. In the case of an insolvent taxpayer not in bankruptcy, the exclusion under the bill applies unless the taxpayer elects to have the present-law exclusion at § 108(a)(1)(B) apply.
Time and method of election.
2.190 The election to exclude discharged indebtedness, which is made on a completed Form 982, must be made on the timely-filed (including extensions) income tax return for the taxable year in which the taxpayer has discharge of indebtedness income that is excludible under Section 108(a). [EN23] However, an automatic extension of six months from the due date of the return (not including extensions) is granted if a taxpayer fails to make the election when filing its tax return by its due date. [EN24] The automatic six-month extension is available only if the taxpayer timely files its return for the year the election should have been made and the taxpayer takes corrective action within the six-month extension period. [EN25] Corrective action means the steps required to file the election in accordance with Section 108 and the regulations and other IRS pronouncements issued thereunder. [EN26] The election must be filed with an original or an amended tax return for the year the election should have been made. [EN27] Note that before Regs. Section 1.108-5 was issued, temporary regulations had allowed the taxpayer to file an election with an amended return, or claim for credit or refund, if the taxpayer established reasonable cause for failure to file the election with the original return.
2.200 In the partnership context, a taxpayer must treat a partnership interest as depreciable real property when reducing adjusted bases under Section 108(c) to the extent the partnership correspondingly reduces the partner’s proportionate interest in the adjusted bases of depreciable real property held by the partnership (inside basis). [EN28] The regulations allow a taxpayer to choose whether or not to request that a partnership reduce the partner’s share of depreciable basis in partnership property. If the partnership grants the request, the taxpayer is able to treat the partnership interest as depreciable real property. [EN29]
Deeds in lieu.
2.210 The tax consequences of a conveyance by the purchaser-mortgagor to the seller-mortgagee in settlement of a purchase money mortgage depend on whether Section 108 applies to the transaction.
Qualified business indebtedness.
2.220 For purposes of Section 108, “qualified business indebtedness” included all types of corporate obligations. As to individuals, “qualified business indebtedness” included only debt incurred or assumed in connection with property used in the taxpayer’s trade or business. Section 108(c)(2) provided that, to the extent the solvent debtor had an insufficient tax basis in depreciable property to cover the full amount of the debt discharged (measured at the beginning of the year after discharge), the remaining amount would be included in the debtor’s income in the year of the discharge.
Example: X buys depreciable realty from Y for $100,000, paying $10,000 in cash and giving Y a purchase money recourse mortgage for $90,000. Y transfers the mortgage to Z. When the value of the property is $80,000, its adjusted basis is $75,000 (as a result of depreciation), and the mortgage has been reduced to $86,000, X conveys the property to Z in satisfaction of the mortgage debt. The amount realized by X appears to be limited to $80,000. X’s gain on disposition of the realty is therefore $5,000 ($80,000 amount realized – $75,000 basis, which will be either Section 1231 gain or ordinary income depending on whether depreciation recapture applies. X has $6,000 of cancellation of indebtedness income in the year of the debt discharge.
Purchase price reduction.
2.230 For transactions occurring after 1980, Section 108(e)(5) provides that a reduction in the amount of a purchase money mortgage by the seller-mortgagee is treated as a purchase price reduction rather than as discharge of indebtedness. The effect of such a reduction is to postpone recognition of gain by the debtor, who must reduce his basis in the subject property by the amount of debt discharged. If the reduction occurs in the context of a transfer back to the seller, the mortgagor has substituted Section 1231(b) or capital gain for cancellation of indebtedness income under Section 61(a)(12). [EN30]
2.240 Section 108(e)(5) does not apply to insolvent purchasers. In addition, it does not apply if the seller assigns the debt or if the debtor has transferred the purchased property. Therefore, if in the above example Y agreed to reduce the mortgage from $86,000 to $80,000 and X retained the property after the reduction, the debt cancellation would be treated as a reduction in the purchase price. X would reduce his basis in the property by $6,000 and recognize no cancellation of indebtedness income in the year of discharge. For a more detailed analysis of Section 108, see 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency.
Conveyance to Mortgagee — Mortgagor without personal liability.
2.250 As a general rule, the voluntary conveyance of mortgaged property to a nonvendor mortgagee in satisfaction of debt results in characterization of the transaction as a sale or exchange. [EN31] The amount realized on such a sale or exchange is the full amount of the mortgage debt. [EN32] The fair market value of the property is not relevant to a determination of the amount realized. [EN33]
2.260 It has been argued that the Supreme Court’s opinion in Crane should limit the amount realized in instances where the outstanding mortgage debt exceeds the fair market value of the property. The argument states:
Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot.
Supreme Court reversal
2.270 However, the “argument” was successful only with the Fifth Circuit before its reversal by the Supreme Court. [EN34] Other cases and most commentators have consistently rejected the theory was intended to carve out an exception to the Crane rule. For example, in affirming the Tax Court opinion in Millar, [EN35] the Third Circuit stated that an analysis of the footnote in the context in which it appeared suggests that the total amount of nonrecourse liabilities which are includible in basis and therefore support deductions (whether depreciation deductions or an offset against sales price) must be considered as an amount realized when discharged. The Supreme Court supported this reasoning in Tufts. Comment: The reasoning behind inclusion of such nonrecourse debt as an amount realized is more compelling where the indebtedness represents refinancing or financing unrelated to the purchase. In such a case, the mortgagor receives nontaxable cash which can be viewed as “advance” sale proceeds. [EN36]
Purchase money Mortgagee.
2.280 The conveyance of property to a purchase money mortgagee in satisfaction of nonrecourse debt encumbering the property is treated as a sale or exchange to the mortgagor. In Freeland v. Comr., [EN37] property was conveyed in satisfaction of a nonrecourse purchase money mortgage when its value was less than the outstanding debt. The conveyance by quitclaim deed also qualified as an abandonment under California law.
Sale or exchange.
2.290 The Tax Court relied on three Supreme Court cases in determining that the transaction constituted a sale or exchange. First, it read Helvering v. Hammel [EN38] as evidencing Congress’ intent that “sale or exchange” be broadly construed. (In Hammel, a foreclosure or involuntary sale was held to constitute a sale or exchange.) Next, the court cited Helvering v. Nebraska Bridge Supply & Lumber Co. [EN39] as support for the proposition that whether a “seller” received consideration is irrelevant in determining if a sale under Section 1211 had occurred. In Nebraska Bridge Supply and Lumber Co., an abandonment of property by allowing it to be sold for taxes constituted a sale or exchange.
Finally, the court viewed these two decisions in concert with Crane v. Comr. [EN40] as authority for its conclusion that a voluntary conveyance to the mortgagee, or a deed in lieu of foreclosure, was a sale or exchange, and that the amount realized by the mortgagor was the full amount of the nonrecourse obligation regardless of the fair market value of the property.
Abandonment — Mortgagor with personal liability.
2.300 The abandonment of property by a mortgagor who is personally liable on the mortgage debt is considered to be a sale or exchange having the consequences to the mortgagor described in VIII, G, 1, c, above. [EN41]
Abandonment — Mortgagor without personal liability.
2.310 Mortgagors who own property as to which a loss would be realized on foreclosure have claimed ordinary loss treatment under certain circumstances, arguing that delivery of a quitclaim deed does not constitute a sale or exchange. Some support had been found for this position in older cases. [EN42] However, after reexamining the early cases in light of Crane, the Tax Court concluded in Freeland that relief from indebtedness is sufficient to support a sale or exchange, [EN43] and announced it would no longer follow earlier cases to the contrary.
Abandonment Equals Sale.
2.320 Subsequent cases have supported the view that an abandonment of mortgaged property effects a sale or exchange in the same manner as a voluntary reconveyance. In Middleton v. Comr., [EN44] the taxpayers determined that mortgaged properties had no foreseeable value and tendered deeds to the mortgagee in lieu of foreclosure. The Tax Court held that the sale or exchange occurred for tax purposes when the deeds were tendered, rather than when the lenders foreclosed on the properties for their own purposes.
2.330 Characterization of an abandonment of property subject to a nonrecourse mortgage as a sale or exchange was further supported in Yarbro v. Comr. [EN-45] The taxpayer in Yarbro argued that abandonment of property subject to nonrecourse debt did not relieve him of any obligation. The court, citing Crane, Tufts, and Nebraska Bridge Supply, discussed above, held to the contrary. The principle that an abandonment constitutes a sale or exchange now appears well established.
EN1 Helvering v. Hammel, 311 U.S. 504 (1941); Rev. Rul. 73-36, 1973-1 C.B. 372. See also Cox v. Comr., 68 F.3d 128 (5th Cir. 1995), aff’g T.C. Memo 1994-189, in which the Fifth Circuit held that a sole shareholder realized gain when his company’s creditor foreclosed on certain real property (which he owned but leased to the corporation for use as its place of business) in satisfaction of two defaulted notes that the executive co-signed for the company. Citing Hammel, the court explained that even though the shareholder received none of the proceeds of the foreclosure, the proceeds were nevertheless credited against his liability, and the amount of debt from which he was relieved was thus determinable.
EN2 Regs. Section 1.1001-2(c), Ex. (8).
EN3 See Aizawa v. Comr., 99 T.C. 197 (1992), aff’d in an unpub. opin. (9th Cir. 1994). In Aizawa, a case of first impression, the Tax Court stated that where there is a clear separation between the foreclosure sale and the unpaid recourse mortgage liability that survives as part of a deficiency judgment, the significance of the amount of the proceeds of the foreclosure sale becomes apparent; the mortgage disappears as security and the personal obligation of the taxpayer to pay the balance of the mortgage obligation survives. The court stated that to conclude that the amount realized is the unpaid mortgage balance in such a case is not an acceptable position because it would require the taxpayer to treat as money received the unpaid mortgage principal obligation from which the taxpayer has not yet been discharged. See also Webb v. Comr., T.C. Memo 1995-486 (amount realized by debtor in foreclosure sale was the amount for which the property was sold, rather than the amount of the indebtedness, because, even though the clerk of court neglected to docket the judgment that resulted from the deficiency, the debtor remained liable for it).
EN4 Malmstedt v. Comr., 578 F.2d 520 (4th Cir. 1978); Rev. Rul. 72- 237, 1972-1 C.B. 51.
EN5 Derby Realty Corp. v. Comr., 35 B.T.A. 335 (1937), nonacq., 1937-2 C.B. 8, withdrawn by acq., 1938-1 C.B. 9; Hawkins v. Comr., 34 B.T.A. 918 (1936), aff’d, 91 F.2d 354 (5th Cir. 1937); Rev. Rul. 70-63, 1970-1 C.B. 36. See also PLR 9540006 (purchaser of a New Jersey tax lien certificate, which vested its holder with an inchoate right to foreclose on tax-delinquent property (subject to the property owner’s right of redemption), will not realize income until the property is conveyed to the certificate holder in a foreclosure proceeding or until the property owner redeems the certificate).
EN6 Hill v. Comr., 40 B.T.A. 376 (1939), rev’d and rem’d, 119 F.2d 421 (6th Cir. 1941).
EN7 Lamm v. U.S., 873 F.2d 194 (8th Cir. 1989).
EN8 Hotz v. Comr., 42 B.T.A. 432 (1940).
EN9 Helvering v. Hammel, 311 U.S. 504 (1941).
EN10 Crane v. Comr., 331 U.S. 1 (1947); Millar v. Comr., 67 T.C. 656 (1977), aff’d, 577 F.2d 212 (3d Cir.), cert. denied, 439 U.S. 1046 (1978). See Regs. Section 1.1001-2.
EN11 Tufts v. Comr. 651 F.2d 1058 (5th Cir. 1981), rev’g 70 T.C. 756 (1979).
EN12 461 U.S. 300 (1983).
EN13 86 T.C. 655 (1986), aff’d, 856 F.2d 1169 (8th Cir. 1988).
EN14 Tufts, 461 U.S. at 310.
EN15 1180 East 63rd St. Building Corp. v. Comr., 12 T.C. 437 (1949).
EN16 Rev. Rul. 70-647, 1970-2 C.B. 38.
EN17 Newhouse v. Comr., 59 T.C. 783 (1973); Lackey v. Comr., 36 T.C.M. 890 (1977).
EN18 Regs. Section 1.1001-2; Parker v. Delaney, 186 F.2d 455 (1st Cir. 1950), cert. denied, 341 U.S. 926 (1951); Chilingeron v. Comr., T.C. Memo 1986-463.
EN19 Regs. Section 1.1001-2(c), Ex. (8). See also Delman v. Comr., 73 T.C. 15 (1979), which predated Regs. Section 1.1001-2(c). See PLR 9245023 (transfer of real estate to bank pursuant to deed in lieu of foreclosure resulted in loss recognized by transferor under Section 1001(a), to the extent the transferor’s basis in the property exceeded the amount realized, but no discharge of indebtedness income).
EN20 Section 108(c).
EN21 Section 108(c)(3). “Qualified acquisition indebtedness” is defined in Section 108(c)(4).
EN22 Section 108(c)(2). See Section 1017.
EN23 See Regs. Section 1.108-5, T.D. 8787, 63 Fed. Reg. 56559 (10/22/98), redesignating former Regs. Section 1.108(c)-1, T.D. 8688, 61 Fed. Reg. 65321 (12/12/96), effective Dec. 23, 1993.
EN24 Regs. Section 301.9100-2(b). The automatic six-month extension may be extended for taxpayers affected by Presidentially declared disasters (Section 7508A) or Armed Forces serving in combat zones (Section 7508). See Rev. Proc. 2001-53, 2001-47 I.R.B. 506.
EN26 Regs. Section 301.9100-2(c).
EN28 Section 1017(b)(3)(C).
EN29 See Regs. Section 1.1071-1(g)(i)- (ii), T.D. 8787, 63 Fed. Reg. 56559 (10/22/98).
EN30 Nutter v. Comr., 7 T.C. 480(1946), acq., 1946-2 C.B. 4. If the transfer, by its terms, is sufficient to extinguish the debt, then there is no discharge of indebtedness income — merely gain or loss on the exchange. See Rev. Rul. 76-111, 1976-1 C.B. 214.
EN31 Parker v. Delaney, 186 F.2d 455 (1st Cir. 1950), cert. denied, 341 U.S. 926 (1951); Lutz & Schramm Co. v. Comr., 1 T.C. 682 (1943), nonacq., 1943 C.B. 35.
EN32 Regs. Section 1.1001-2(a)(4)(i); Crane v. U.S., 331 U.S. 1 (1947); Delman Est. v. Comr., 73 T.C. 15 (1979); Millar v. Comr., 67 T.C. 656 (1977), aff’d on this issue, 577 F.2d 212 (3d Cir.), cert. denied, 439 U.S. 1046 (1978); Woodsam Assocs., Inc. v. Comr., 16 T.C. 649 (1951), aff’d, 198 F.2d 357 (2d Cir. 1952); Rev. Rul. 76-111, 1976-1 C.B. 214.
EN33 Regs. Section 1.1001-2(b); Millar v. Comr., 67 T.C. 656 (1977), aff’d on this issue, 577 F.2d 212 (3d Cir.), cert. denied, 439 U.S. 1046 (1978).
EN34 See Adams, “Exploring the Outer Boundaries of the Crane Doctrine; An Imaginary Supreme Court Opinion,” 21 Tax L. Rev. 159 (Jan. 1966). But see Tufts v. Comr., 651 F.2d 1058 (5th Cir. 1981), rev’g 70 T.C. 756 (1979) (fair market value of property secured by nonrecourse debt limits extent to which debt is includible in amount realized upon a disposition of the property). The Supreme Court reversed Tufts in 461 U.S. 300 (1983).
EN35 Millar v. Comr., 577 F.2d 212 (3d Cir.), cert. denied, 439 U.S. 1046 (1978).
EN36 Lutz & Schramm Co. v. Comr., 1 T.C. 682 (1943), nonacq., 1943 C.B. 35.
EN37 74 T.C. 970 (1980).
EN38 311 U.S. 504 (1941).
EN39 312 U.S. 666 (1941).
EN40 331 U.S. 1 (1947).
EN41 Rogers v. Comr., 103 F.2d 790 (9th Cir. 1939), cert. denied, 308 U.S. 580 (1979); Pender v. Comr., 110 F.2d 477 (4th Cir.), cert. denied, 310 U.S. 650 (1940).
EN42 Stokes v. Comr., 124 F.2d 335 (3d Cir. 1941); Jamison v. Comr., 8 T.C. 173 (1947); Comr. v. Hoffman, 117 F.2d 987 (2d Cir. 1941).
EN43 This is consistent with Regs. Section 1.1001-2.
EN44 693 F.2d 124 (11th Cir. 1982), aff’g per curiam 77 T.C. 310 (1981).
EN45 737 F.2d 479 (5th Cir. 1984), cert. denied, 105 S. Ct. 959 (1985). See also L&C Assoc. v. Comr., 188 F.3d 866 (7th Cir. 1999).
Mortgage Forgiveness Debt Relief Act: IRS Q&A’s
What is the Mortgage Forgiveness Debt Relief Act of 2007?
2.240 The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
What does that mean?
Usually, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude certain cancelled debt on your principal residence from income.
Does the Mortgage Forgiveness Debt Relief Act of 2007 apply to all forgiven or cancelled debts?
No, the Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.
What about refinanced homes?
Debt used to refinance your home qualifies for this exclusion, but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified.
Does this provision apply for the 2007 tax year only?
It applies to qualified debt forgiven in 2007, 2008 or 2009.
If the forgiven debt is excluded from income, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and the Form 982 must be attached to your tax return.
Do I have to complete the entire Form 982?
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach the Form 982 to your tax return.
Where can I get this form?
You can download the form at IRS.gov, or call 1-800-829-3676. If you call to order, please allow 7-10 days for delivery.
How do I know or find out how much was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by January 31, 2008. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.
Can I exclude debt forgiven on my second home, credit card or car loans?
Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion.
If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the “insolvency” exclusion. Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982.
Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
There is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982, page 4.
Is there anything else I need to know before filing?
Yes. Because the Mortgage Forgiveness Debt Relief Act of 2007 was passed so late in the year, the software systems used by tax preparers and at the Internal Revenue Service need to be updated to accept the revised Form 982. The IRS expects to be able to process the new Form 982 electronically on March 3, 2008.
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