Over the past several years as taxpayers have endured the Great Recession the IRS has escalated the number of federal tax liens filed against delinquent taxpayers. The IRS aggressive use of liens has been criticized by the National Taxpayer Advocate in her annual report to congress and the IRS Advisory Council in its annual report to the Commissioner. IRS recently announced a new, more flexible attitude in policies and programs to help taxpayers pay back taxes and avoid tax liens.
Robert E. McKenzie
BEFORE THE PROCESS BEGINS
Bankruptcy Code Tax Compliance Requirements
Tax Returns Due After the Bankruptcy Filing. For all bankruptcy cases filed after October 16, 2005, the Bankruptcy Code provides that if the debtor does not file a tax return that becomes due after the commencement of the bankruptcy case, or obtain an extension for filing the return before the due date, the taxing authority may request that the court either dismiss the case or convert the case to a case under another Chapter of the Bankruptcy Code. If the debtor does not file the required return or obtain an extension within 90 days after the request is made, the bankruptcy court must dismiss or convert the case.
Tax Returns for Tax Periods Ending Before the Petition Date in Chapter 13 Cases. For bankruptcy cases filed after October 16, 2005, the Bankruptcy Code requires Chapter 13 debtors to file all required tax returns for tax periods ending within 4 years of the debtor’s bankruptcy filing. All such federal tax returns must be filed with the IRS before the date first set for the first meeting of creditors. The debtor may request the trustee to hold the meeting open for an additional 120 days to enable the debtor to file the returns (or until the day the returns are due under an automatic IRS extension, if later). After notice and hearing, the bankruptcy court may extend the period for another 30 days. Failure to timely file the returns can prevent confirmation of a Chapter 13 plan and result in either dismissal of the Chapter 13 case or conversion of the case to a Chapter 7 case.
Trustees may require the debtor to submit copies or transcripts of the debtor’s returns as proof of filing.
CREATION OF THE BANKRUPTCY ESTATE
Bankruptcy proceedings begin with the filing of a petition in bankruptcy court, and that filing creates the bankruptcy estate. Typically an individual debtor files either a Chapter 7 or Chapter 11 Petition . In all other bankruptcy proceedings, including Chapter 7 or Chapter 11 bankruptcy cases dismissed by the Bankruptcy Court, the debtor continues to file income tax returns as though there were no bankruptcy and there were no separate taxable bankruptcy estate. When a separate taxable bankruptcy estate is created, the estate inherits and takes into account the following income attributes of the debtor :
1. Net operating loss carryovers determined under IRC 172.
2. Charitable contribution carryover determined under IRC 170(d)(1).
3. Recovery of tax benefit items for any amount to which IRC 111 applies.
4. Carryovers of any credit, and all other items that, except for the commencement of the bankruptcy case, the debtor would be required to take into account with respect to any credit.
5. Capital loss carryovers determined under IRC 1212.
6. The debtor’s basis, holding period, and character of any asset acquired from the debtor (unless acquired by sale or exchange).
7. The debtor’s accounting method.
8. Other tax attributes of the debtor, to the extent provided by regulation.
The bankruptcy estate generally consists of all of the assets of the person or entity filing the bankruptcy petition, unless property is exempt under USC 522 . Individual estates are allowed to opt out of the federal exemption scheme and determine what property is exempt for resident debtors. Most states have done so. Upon conclusion or dismissal of the bankruptcy proceedings, the debtor takes over any remaining tax attributes including those that first arose during administration of the bankruptcy estates .
BACKGROUND AND GENERAL LEGAL PRINCIPLES
The commencement of a bankruptcy case creates an estate, which generally includes all legal or equitable interests of the debtor in property as of the commencement of the case . Specific exclusions apply, however . Exempt property and abandoned property are initially part of the bankruptcy estate, but are subsequently removed from the estate. By contrast, property excluded from the estate is never included in the estate.
Plain Language Practice Tip! Here’s what’s going on: the bankruptcy estate property will be used to pay the debtor’s creditors. The bankruptcy estate is treated as a separate taxable entity from the debtor. The trustee or debtor-in-possession is responsible for preparing and filing the estate’s tax returns and paying its taxes. The debtor remains responsible for filing his or her own returns and paying taxes on income that does not belong to the estate.
Bankruptcy law determines which of a debtor’s assets become part of a bankruptcy estate. A transfer (other than by sale or exchange) of an asset from the debtor to the bankruptcy estate is not treated as a disposition for income tax purposes. Consequently, the transfer does not result in gain or loss, recapture of deductions or credits, or acceleration of income or deductions. For example, the transfer of an installment obligation to the estate would not accelerate gain under the rules for reporting installment sales. The estate is treated the same way the debtor would be regarding the transferred asset.
When the bankruptcy estate is terminated or dissolved, any resulting transfer (other than by sale or exchange) of the estate’s assets back to the debtor is also not treated as a disposition. The transfer does not result in gain or loss, recapture of deductions or credits, or acceleration of income or deductions to the estate.
The abandonment of property by the estate to the debtor is a nontaxable disposition of property. If the debtor received abandoned property from the estate, the debtor has the same basis in the property that the estate had.
Confirmation of a Chapter 11 plan of reorganization generally vests all the property of the estate in the debtor, except as otherwise provided in the plan or in the court order confirming the plan . If no plan is confirmed and a bankruptcy case is dismissed, the property of the estate generally revests in the debtor, unless the court orders otherwise .
Trustee or Debtor in Possession
When a trustee is appointed pursuant to section 1104 of the Bankruptcy Code, the debtor generally must turn over to the trustee control over the assets of the bankruptcy estate. In most Chapter 11 cases, a trustee is not appointed and the debtor (referred to as the debtor in possession) remains in control of the property of the bankruptcy estate. Under section 1107(a) of the Bankruptcy Code, the debtor in possession must perform all the functions and duties of a trustee, except for the duties specified in Bankruptcy Code section 1106(a)(2), (3) and (4).
Because the bankruptcy estate is a separate taxable entity, the trustee or debtor in possession must obtain an employer identification number (EIN) for the estate . The trustee or debtor in possession uses the EIN on any tax returns filed for the estate.
Attribution of Income
IRC Section 1398(e)(1) provides that the gross income of the estate includes the gross income of the debtor to which the estate is entitled under the Bankruptcy Code. IRC Section 1398(e)(2) provides that the gross income of the debtor does not include any item to the extent the item is included in the gross income of the bankruptcy estate.
Determination of Deduction or Credit
In general, the determination of whether or not any amount paid or incurred by the estate is allowable as a deduction or credit to the estate shall be made as if the amount were paid or incurred by the debtor and as if the debtor were still engaged in the trades and businesses, and in the activities, the debtor was engaged in before the commencement of the case . The estate is, however, specifically allowed a deduction for administrative expenses allowed under section 503 of the Bankruptcy Code and for any fee or charge assessed against the estate under Chapter 123 of title 28 of the United States Code. I.R.C. § 1398(h)(1).
The individual debtor must continue to file his or her own individual tax returns during the bankruptcy proceedings. I.R.C. § 6012(a)(1).
Plain Language Practice Tip! – Ask what type of bankruptcy your client has entered so you know the filing requirements.
Individuals in Chapter 12 or 13
The bankruptcy estate is not treated as a separate entity for tax purposes when an individual files a petition under Chapter 12 (Adjustment of Debts of a Family Farmer or Fisherman with Regular Annual Income) or 13 (Adjustment of Debts of an Individual with Regular Income) of the Bankruptcy Code. The individual should continue to file the same federal income tax returns that were filed prior to the bankruptcy petition. Chapter 13 reorganizations are not available to corporations or partnerships and are only available to individuals.
On the debtor’s return, report all income received during the entire year and deduct all allowable expenses. Do not include in income any debts canceled because of the debtor’s bankruptcy. To the extent the debtor has any losses, credits, or basis in property that were reduced because of canceled debt, these reductions must be included on the debtor’s return.
Individuals in Chapter 7 or 11
If the debtor is an individual who files for bankruptcy under Chapter 7 or 11, the bankruptcy estate is treated as a new taxable entity, separate from the individual taxpayer.
The estate in a Chapter 7 case is represented by a trustee. The trustee is appointed under the Bankruptcy Code to administer the estate and liquidate any nonexempt assets of the estate. In Chapter 11, the debtor often remains in control of the assets as a “debtor-in-possession” and acts as the bankruptcy trustee.
If the debtor filed a Chapter 7 or 11 case, the debtor must file a Form 1040 for the tax year involved. The bankruptcy trustee files a Form 1041 for the bankruptcy estate. If the debtor is in Chapter 11 bankruptcy and remain as the debtor-in-possession, the debtor must file both a Form 1040 and the Form 1041 for the bankruptcy estate (if the estate meets the return filing requirements).
Do not include on the debtor’s individual income tax return the income, deductions, or credits that belong to the bankruptcy estate. Also, do not include as income on the debtor’s return any debts canceled because of bankruptcy. However, the bankruptcy estate must reduce certain losses, credits, and the basis in property (to the extent of these items) by the amount of canceled debt.
If a husband and wife file a joint bankruptcy petition and their bankruptcy estates are jointly administered, their estates must be treated as two separate entities for tax purposes. Two separate tax returns must be filed (if they separately meet the filing requirements).
Changes brought with BAPCPA
Section 321 of BAPCPA made several changes to Chapter 11, effective for bankruptcy cases filed by individuals on or after October 17, 2005. Although many of the provisions that apply to individual Chapter 11 cases now operate in a manner similar to the provisions that apply in Chapter 13 cases, section 1398 of the Internal Revenue Code has not been amended and continues to apply to individual Chapter 11 cases, but not to Chapter 13 cases. Based on section 1115 of the Bankruptcy Code, read in conjunction with section 1398(e)(1) of the Internal Revenue Code, the debtor’s gross earnings from post-petition services and gross income from post-petition property are, in general, includible in the bankruptcy estate’s gross income, rather than in the debtor’s gross income.
Conversion to Chapter 13
If a Chapter 11 case is converted to a Chapter 13 case, the Chapter 13 estate is not a separate taxable entity and earnings from post-conversion services and income from property of the estate realized after the conversion to Chapter 13 are taxed to the debtor. I.R.C. § 1399.
Conversion to Chapter 7
If the Chapter 11 case is converted to a Chapter 7 case, section 1115 will not apply after conversion and earnings from post-conversion services will be taxed to the debtor, rather than the estate. 11 U.S.C. § 541(a)(6). In such a case, the property of the Chapter 11 estate will become property of the Chapter 7 estate. Any income on this property will be taxed to the estate even if the income is realized after the conversion to Chapter 7.
If a Chapter 11 case is dismissed, the debtor is treated as if the bankruptcy case had never been filed and as if no bankruptcy estate had been created .
Taxation of Income from Property Excluded From the Estate
For Chapter 11 cases filed by individuals on or after October 17, 2005, the estate’s gross income includes gross income from property held by the debtor when the case commenced (“pre-petition property”). There are certain exceptions to this general rule, however. The gross income on pre-petition property is included in the gross income of the debtor, rather than the estate, if the pre-petition property is excluded from the estate and the gross income is subject to taxation. Also, the gross income on pre-petition property is included in the gross income of the debtor, rather than the estate, after the pre-petition property is removed from the estate by exemption or abandonment.
TAXATION OF BANKRUPTCY ESTATE
A bankruptcy estate must file a separate tax return from the debtor. Form 1041 (U.S. Fiduciary Income Tax Return) is used for the estate, and it serves as a transmittal for the debtor’s Form 1040 (U.S. Individual Income Tax Return). Bankruptcy begins with the filing of the petition, and continues until the proceeding is concluded.
The estate is entitled to one personal exemption and to the standard deduction for a married person filing separately (if the estate does not itemize deduction). Income tax rates are those for “Married Persons Filing Separately .” The estate does not file a tax return if its gross income is less than the amount of the standard deduction and one personal exemption . Because a bankruptcy estate computes income like an individual and IRC 1398 contains no provision allowing it, a bankruptcy estate gets no deductions for distributable net income.
Plain Language Practice Tip! – Caution! – Responsibility for filing Form 1041 lies with the fiduciary of the estate. That person may be your client, because it is either the trustee (if one is appointed), or the debtor in possession (your client, if one is not) .
The bankruptcy estate can adopt either a calendar year or a fiscal year since it is taxed as a separate new entity . In addition, the estate can change its tax year once without IRS approval. This allows the trustee to end the estate’s tax year before the expected termination of the estate (usually at the conclusion of bankruptcy), and then submit a return for the short year for a prompt determination of tax liability under 11 USC 505(b). See “Request for Prompt Determination of Liability” below.
GROSS INCOME OF THE ESTATE
The gross income of the estate includes all gross income of the debtor that is received or accrued after commencement of the bankruptcy proceedings and to which the estate is entitled under the bankruptcy code . Any income received or accrued by the debtor before commencement of the bankruptcy proceeding is excluded from the bankruptcy estate’s gross income. Accrual basis taxpayers, gross income that accrued before the commencement of the bankruptcy proceedings and was included in the debtor’s gross income becomes property of the estate once the bankruptcy petition is filed. So all income earned before but paid after the filing of the bankruptcy petition belongs to the bankruptcy estate.
Partnership or S Corporation interests that an individual owns when then bankruptcy petition is filed become property of the estate under 11 USC 541. Neither the bankruptcy code nor IRC 1398 require a partner’s or partnership’s tax year to close on the date a bankruptcy petition is filed. So, it appears when a petition is filed prior to the close of the partnership’s tax year, all income and loss of the partnership in that year and all the subsequent years of the bankruptcy proceedings is to be reported on the tax return of the bankruptcy estate. Income or loss of an S Corporation is to be allocated among shareholders on a pro rata basis . Accordingly, the debtor and bankruptcy estate should each report a pro rata share of income or loss from the corporation in the year that the debtor files a bankruptcy petition.
DEDUCTIONS, CREDITS, AND WAGES
Amounts paid or incurred by the bankruptcy estate will be allowed as a credit, deduction, or as wages if such amounts would have been similarly treated by the debtor for trades and business is engaged in before the commencement of the bankruptcy .
All administrative expenses allowed under 11 USC 503 and any fees or charges assessed against the estate under 28 USC Chapter 123, to the extent not allowed under any other provision are allowed as deductions by the bankruptcy estate. Administrative expenses generally arise after the commencement of the bankruptcy action, therefore, any accrued expenses properly deducted by the debtor before bankruptcy cannot also be deducted by the estate when paid. Because administrative expenses are limited to costs not disallowed under any other provision of this title, they are subject to the deduction disallowance rules contained in the code. Administrative expenses are those incurred to preserve the estate, and include wages, salaries, bank charges or commissions, including fees paid to attorneys and accountants for services performed subsequent to filing the bankruptcy petition.
Administrative expenses incurred but not deducted in the current year can be carried back three years and forward seven years. This rule also applies to unused current year liquidation and reorganization expenses. An expense that would be classified as an operating expense for the debtor had the debtor not been in bankruptcy, and which is also an administrative expense to the estate, could seemingly be carried over under the normal carryover rules for net operating losses. Calculation of the administrative costs carryover must be made after a separate net operating loss carryover under IRC 172(b(2) is made. The administrative expense carryover is used after the net operating loss has been applied.
Plain Language Practice Tip! – Caution! – The catch is, the carrybacks and carry forwards are only available to the estate, not the debtor .
NET OPERATING LOSS CARRYBACK
A net operating loss incurred by the estate can be carried back to the debtor’s pre- bankruptcy tax years, as well as to previous tax years of the estate .
REQUEST FOR PROMPT DETERMINATION OF LIABILITY.
The trustee or debtor in possession can request the IRS to make prompt determination of the estate’s tax liability . By following Rev. Proc. 2006-24, 2006-22 I.R.B. 943, http://www.irs.gov/irb/2006-22_IRB/ar12.html, the bankruptcy trustee may request a determination of any unpaid tax liability incurred by the bankruptcy estate during the administration of the case by filing a tax return and a request for such a determination with the IRS. For cases filed after October 16, 2005, unless the return is fraudulent or contains a material misrepresentation, the estate, trustee, debtor, and any successor to the debtor are discharged from liability for the tax upon payment of the tax:
1. As determined by the IRS,
2. As determined by the bankruptcy court, after the completion of the IRS examination, or
3. As shown on the return, if the IRS does not:
a. Notify the trustee within 60 days after the request for the determination that the return has been selected for examination, or
b. Complete the examination and notify the trustee of any tax due within 180 days after the request (or any additional time permitted by the bankruptcy court).
Plain Language Practice Tip! Because the debtor is responsible for any unpaid tax liability of the bankruptcy estate, the debtor should urge the trustee to make the request. Tax returns filed by the trustee are, upon written request, open for inspection by the debtor . The trustee of the estate is responsible for paying the income tax liability of the estate. The debtor can be liable for the tax, however, if the assets of the estate are not sufficient to pay the tax .
ABANDONMENT OF PROPERTY
The trustee can, after notice and a hearing, abandon any property of the estate that is burdensome or that is inconsequential in value and benefit to the estate . The right is best used when the property has a basis below its fair market value, or when the property is subject to a nonrecourse secured claim, since the sale or transfer of the property to a creditor will produce a tax liability to the estate. It is important to note that abandonment of the property does not include abandonment of proceeds after a taxable sale or exchange.
TAXATION OF THE INDIVIDUAL DEBTORS
SHORT TAX YEAR ELECTION
The creation of a separate taxable bankruptcy estate for individuals who file Chapter 7 or Chapter 11 petitions does not include the taxation of the individual debtor. When no separate taxable bankruptcy is created, the debtor must file tax returns as though there was no bankruptcy proceeding. However, when a separate bankruptcy estate is created under the individual Chapter 7 or Chapter 11 proceeding, the debtor can elect to close his or her tax year on the day before the bankruptcy proceeding commences . The debtor must have property other than exempt property to make the election.
If the election is not made the tax year of the debtor is not affected by the bankruptcy. The debtor will file Form 1040 (U.S. Individual Income Tax Return) for the entire year, but will only include income and deductions that accrued before the commencement of the bankruptcy, as well as those accruing after bankruptcy that relate to property acquired after bankruptcy or exempt property . When the election is made, the debtor’s tax year is divided into two short tax years:
1. The first starts when the debtor’s tax year would have started had the election not been made (January 1st for most individuals) and ends the day before the bankruptcy petition is filed.
2. The second begins the day the bankruptcy petition is filed and ends when the debtor’s tax year would have ended had the election not been made (December 31 for most individuals).
Tax computations for the first short year are collected from the bankruptcy estate because it is a liability of the debtor prior to bankruptcy. If the estate does not pay the tax it becomes collectable from the individual debtor after the bankruptcy proceeding concludes .
WHEN TO ELECT SHORT YEARS
An individual debtor who has taxable income for the short tax year ending the day before the bankruptcy petition is filed, should make the IRC 1398(d)(2) election. The tax liability of such income would be a claim against the estate. Conversely, the debtor should not make the election if he or she has a loss for the first short year tax year because the loss would be carried over to the bankruptcy estate. By not making the election, the loss would become part of the debtor’s return for the full year and could then be used to offset income earned later in the year. If the debtor had a loss for the entire year, it would become a net operating loss carryover not acquired by the bankruptcy estate and thus, available to the debtor.
The election is made by the debtor filing a tax return for the short tax year by the fifteenth day of the fourth full month following the end of the first short tax year. For example, if the debtor files bankruptcy on March 15th, the tax return for the short period between January 1 and March 14 must be filed by July 15 of that same year. The debtor’s spouse makes this election by filing jointly with the debtor. The debtor should write “Section 1398 Election” across the top of the return. The debtor and spouse can also make the election by attaching a “Statement of Election” to a properly filed tax return extension, in lieu of a tax return, for the first short year. The statement must provide that the debtor, and his spouse, if applicable, desires to close his tax year by making a Section 1398 Election . An election is irrevocable. In addition, the debtor is required to annualize taxable income for each short tax year in the same manner as if a change of accounting periods has been made.
Subsequent Bankruptcy of Spouse
The debtor’s spouse who subsequently files a Chapter 7 or Chapter 11 petition in the same tax year as the debtor can make a separate election, even if the spouse earlier jointly filed with the debtor. The debtor can join the election, provided all the requirements for a joint return are satisfied. The following example illustrates the IRC 1398 Election:
1. Assume the husband and wife for calendar tax years, that a bankruptcy case involving only the husband commenced on January 15, 1993, and that a bankruptcy case involving only the wife commenced on May 10, 1993.
2. If the husband did not make an election, his tax year would not be affected; i.e., it did not terminate on January 14. If the husband did make an election, his short tax year would be January 1 through January 14; his second short tax year began January 15. The tax return for his first short tax year was due on May 15. The wife could have joined the husband’s election but only if they filed a joint return for the tax year January 1 through January 14.
3. The wife could have elected to terminate her tax year effective May 10. If she did, and if the husband had not made an election or if the wife had not joined in the husband’s election, she would have two tax years in 1993 — the first from January 1 through May 9, and the second from May 9 through December 31. The tax return for her short year would be due September 15, 1993. If the husband had not made an election to terminate his tax year on January 14, the husband could have joined an election by his wife, but only if they filed a joint return for the tax year January 1 through May 9. IF the husband made an election but the wife had not joined in the husband’s election, the husband could not have joined in an election with the wife to terminate her tax year on May 9, since they would not have filed a joint return for such year.
4. If the wife made the election relating to her own bankruptcy case, and had joined the husband in making an election relating to his case, she would have had two additional years with respect to her 1993 income and deductions — the second short year would have been January 15 through May 9, and the third short year would have been May 10 through December 31. The husband could have joined in the wife’s election if they could have filed a joint return for the second short tax year. If the husband joined in the wife’s election, they could have filed joint returns for the short tax year ending December 31 but would not have been required to do so.
CONCLUSION OF BANKRUPTCY
At the end of the bankruptcy proceedings the debtor inherits the tax attributes of the bankruptcy estate that were not reduced by debt discharge. Note, however, that the estate’s method of accounting is not carried over to the debtor, even though the estate originally inherited the debtor’s accounting method . The debtor is precluded from carrying back a net operating loss occurring on a tax year ending after commencement of the bankruptcy to any pre-bankruptcy tax year .
INCOME FROM DISCHARGE OF INDEBTEDNESS
Once a discharge is secured the debtor must determine if the discharge results in income. A debtor usually realizes income when a debt is cancelled or forgiven, unless the forgiveness is a gift or bequest . Income is realized because the forgiveness makes assets available to the debtor that were previously offset by the debt. But a debtor can exclude from gross income any debt discharged in a bankruptcy proceeding .
Although no income is realized from a debt discharged in bankruptcy, the excluded amount must be reflected in one of two ways. The debtor, or estate in a Chapter 7 or 11 case can either:
1. Reduce tax attributes by that amount, or
2. Elect to reduce basis in depreciable property by the excluded amount .
For this purpose, the debtor or estate can elect to treat as depreciable property realty held as inventory or held primarily for sale under IRC 1221(l). The amount by which basis can be reduced, however, is limited to the aggregate adjusted basis of the depreciable property at the beginning of the tax year following the tax year of the discharge .
Any part of the excluded amount that does not go to reduce basis is then applied to reduce other tax attributes.
The bankruptcy exclusion for discharged debt is closely related to exclusions for debts discharged when:
1. The taxpayer is insolvent , or
2. A solvent farmer’s discharge of “qualified, farm indebtedness .”
3. A solvent taxpayer’s discharge of debt on qualified depreciable real property .
DISCHARGE OF AN INSOLVENT DEBTOR
An insolvent debtor can exclude from gross income discharged debt up to the amount of his insolvency . Insolvency equals the excess of liabilities over the fair market value of assets immediately before the debt discharge . But, an insolvent debtor who is solvent following the debt discharge realizes income to the extent post-discharge assets exceed post-discharged liabilities. Excluded amounts can either reduce tax attributes or reduce depreciable assets in the same manner as in bankruptcy.
Plain Language Practice Tip! – Caution! – Beware of property transferred to satisfy creditors. The insolvency exception only applies to debt cancellation income and only to the extent of the debtor’s insolvency. Income might result from such transactions. In a bankruptcy case, a property transfer to creditors that results in forgiveness or discharge will not create income.
DISCHARGE OF FARM DEBT
A solvent farmer can exclude from gross income “qualified farm indebtedness” discharge incurred after April 9, 1986 . If the farmer is solvent, this insolvency exclusion is first applied (to the extent of the insolvency) before application of the qualified farm debt exclusion. Qualified farm indebtedness must meet two requirements:
1. The debt must have been incurred in connection with the trade or business of farming, or be secured by farm land or equipment used in the business.
2. At least 50% of aggregate gross receipts for the three tax years preceding the tax year of the discharge must be attributable to the trade or business of farming.
The discharge must be a “qualified person,” that is a government agency or person not related to the debtor, that is actively and regularly engaged in lending money, and that is not the same person that sold the farmer property for which the debt was incurred. The amount of qualified farm debt excluded from income is limited to the combined total of adjusted tax attributes and the aggregate adjusted basis in qualified property as at the beginning of the tax year following the tax year of discharge. Qualified property is any property used or held for use in trade or business or investment property . In case of an insolvent farmer, the adjusted basis of qualified property and adjusted tax attributes are determined after any reduction on the amount of the exclusion related to insolvency.
NO DEBT DISCHARGE INCOME ON SOME REAL ESTATE DEBT
The 1993 tax law bailed out some individual taxpayers who would otherwise have debt discharge income due to a decline in the value of business realty securing the debt . Previously, a taxpayer whose debt was reduced or discharged had cancellation of debt (COD) income unless the taxpayer was insolvent or was involved in a Title 11 bankruptcy proceeding, the debt was qualified farm debt, or the debt was held by the property’s seller. Under the 1993 law, taxpayers can elect to exclude income from a discharge of qualifying realty debt after 1992; the excluded COD income reduces the taxpayer’s basis in depreciable real property.
The exclusion only applies to the forgiveness of debt on trade or business realty. The excluded COD income is limited to the amount by which the debt (before discharge exceeds the property’s FMV, and can not be more than the taxpayer’s total basis in depreciable realty. The debt must have been incurred or assumed by the taxpayer in connection with real property used in a trade or business, and must be secured by that property. Debt incurred or assumed after 1992 only qualifies if it is used to buy, build, or substantially improve trade or business realty that secures it, or to refinance existing qualified debt (to the extent of the unpaid balance of the old debt.
Plain Language Practice Tip! The term “trade or business” should be broad enough to include many rental income properties. Here are two definitions that help interpret this material:
• Basis reduction: The amount of excluded COD income reduces the basis in the taxpayer’s business realty using the rules of CODE Sec. 1017, as modified by the new law. If the taxpayer disposes of the property before the end of the tax year in which the debt was discharged, the basis is reduced immediately before the disposition.
• Disposition of Property. If the basis of depreciable realty is reduced due to the new COD exclusion and the property later is sold, the basis reduction is treated as if it had been claimed as depreciation for purposes of the Code Sec. 1250 recapture rules (however, it is not figured into the calculation of the amount by which actual depreciation claimed exceeds straight line depreciation).
Plain Language Practice Tip! COORDINATION OF EXCLUSIONS
• For purposes of the exclusions the bankruptcy rules take precedence over the insolvency rules
• The insolvency rules take precedence over the rules for qualified farm debt and the qualified real property business exclusion
• The insolvency exclusion, qualified farm debt exclusion, and the qualified real property exclusion do not apply to a discharge that occurs in bankruptcy
• The insolvency exclusion is applied first before applying the qualified debt exclusion .
• The principal residence exclusion takes precedence over the insolvency exclusion, unless otherwise elected .
REDUCTION OF DEBTOR’S TAX ATTRIBUTES
The amount of discharge debt excluded from income reduces the debtor’s or estate’s tax attributes in the following order:
1. Net operating losses and carryovers. This applies to any net operating loss for, and any net operating loss carryover to the discharge’s tax year.
2. General business credit carryovers. This includes any carryover to and from the discharge’s tax year of:
a. IRC 30 — credit for increasing research activities, or
b. IRC 38 — general business credit.
3. Capital losses and carryovers. This includes any capital loss for the discharge’s tax year and any capital loss carryover under IRC 1212 of the discharge year.
4. Reduction of asset basis. The debtor’s basis in depreciable and non-depreciable assets are reduced only to the extent it exceeds the amount of liabilities after discharge.
5. Foreign tax credit carryovers. This includes any carryovers of foreign tax credit to and from the discharge’s taxable year .
The net operating loss, capital losses, and carryovers, and the basis of depreciable property are reduced on a dollar for dollar basis. Credit carryovers are reduced at a rate of 33 cents for each dollar of discharge .
ORDER OF REDUCTION
The reduction in each category of carryovers is made in the order of tax years in which items would be used, determined as if the discharge debt amount were included in income. The net operating losses are followed by carryovers in the order in which they arose. Investment credit carryovers are reduced on a FIFO basis. Other credit carryovers are reduced in the order they would be used against taxable income. All reductions are made after the tax for the discharge year is computed. Income limits on the use of credits are disregarded .
Except for the reduction of assets each of the above the categories must be reduced to zero before any remaining amount reduces the next category. Some or all of the discharged debt amount may remain after reduction of the first three categories of the tax attributes listed above. If so, the remaining discharge debt amount is applied to reduce the basis of the taxpayer’s assets held by the debtor at the beginning of the tax year after the discharge’s taxable year. This amount cannot exceed the amount by which the basis in all assets (depreciable and non-depreciable) held by the debtor immediately after the discharge exceeds the amount of the debtors remain on discharge liabilities .
Specifics: Unless the debtor chooses to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property, use the amount of canceled debt to reduce the tax attributes in the order listed below:
• Net operating loss. Reduce any NOL for the tax year in which the debt cancellation takes place, and any NOL carryover to that tax year.
• General business credit carryovers. 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. 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. Reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.
• Basis. This reduction applies to the basis of both depreciable and nondepreciable property.
• Passive activity loss and credit carryovers. 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.
Making the reduction. Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing NOLs 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 11. In an individual bankruptcy under chapter 7 or 11 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.
The following rules apply to the extent indicated when any amount of the debt cancellation is used to reduce the basis of assets
When to make the basis reduction. Reductions in basis due to debt cancellation are made at the beginning of the tax year following the cancellation. The reduction applies to property held at that time .
Bankruptcy and insolvency reduction limit. The reduction in basis for 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.
Exempt property under title 11. If debt is canceled in a bankruptcy case under title 11 of the United States Code, do not reduce the basis in property that the debtor treats as exempt property under section 522 of title 11.
Election to reduce basis in depreciable property first. 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. The debtor 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. The debtor must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, the debtor can only revoke it with IRS approval. However, if the debtor establishes reasonable cause, the debtor may make the choice with an amended return or claim for refund or credit.
Making elections. 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.
Recapture of basis reductions. 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 corresponding to the basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of the basis reduction as a depreciation deduction and by treating any such basis-reduced property that is not already either IRC section 1245 or IRC section 1250 property as IRC section 1245 property. In the case of IRC section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation.
Tax Attribute Reduction Example
Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 2007, 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 FMV 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 2008 of $5,000. He also has an NOL of $2,000 and a $3,000 NOL carryover from 2005. 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 NOL, next, his $3,000 NOL carryover from 2005, 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 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.
Plain Language Practice Tip! Before deciding whether to reduce tax attributes or to reduce basis, the debtor should review his situation keeping in mind the following:
1. If taxable income is anticipated in the near future, it is usually best to reduce depreciable property and preserve operating loss and credit carryovers so as to offset taxable income and taxes while increasing cash flow.
2. If net operating loss carryovers and net credit carryovers are going to expire on you, it is usually best to reduce these tax attributes instead of losing them.
3. If depreciable property that might be reduced will be held for a long period of time, it is usually best to reduce depreciable property and defer any tax consequences.
4. If the sale of a bankrupt corporation is planned, the basis reduction might be preferable instead of a tax attribute reduction for long term deferral and a saving of tax attributes that might be the main consideration of the sale.
State and local taxes should be tested under each alternative to maximize opportunities.