Cancellation of Debt for Individuals - Presentation for Enrolled Agents

1. Cancellation of Debt for Individuals -Presentation for Enrolled Agents October 16, 2008 Tucson, AZ by Tom Rex CPA

2. General Overview Cancellation Of Debt for Individuals

3. Where are you in the matrix? • Know where you are so you don’t get lost. • It’s easy to go down the wrong rabbit hole! • esp. with PDF documents and hyperlinks

4. New IRS Pub 4681 Issued in June 2008

5. COD income • Taxable unless there’s an • Exception or • Exclusion (these are all defined) • If there’s an exclusion, then taxpayer must reduce the tax attributes • In other words, if no exceptions or exclusions, COD is taxable income! It’s helpful to think in both directions.

6. Canceled debts - • General rule • COD income in whole or in part is taxable unless exceptions or exclusions apply • E.g., discounts and loan modifications that includes principal reduction (personally liable or not) • Taxable as COD income unless exceptions or exclusions apply per Pub 4681, page 3

7. Canceled debts - • Exceptions • Amounts Otherwise Excluded From Income • Student Loans • Deductible Debt • Price Reduced After Purchase • These exceptions apply before the exclusions per Pub 4681, page 3 and 4

8. If there’s an exclusion • Which one to use? • Which elections to make for part I of Form 982 • How much is excluded? • Depends • There may be an exclusion limitation • Exclusions are for amount on part I, line 2 of Form 982

9. COD - exclusions • Title 11 bankruptcy case • Insolvency • Qualified farm indebtedness • Qualified real property business indebtedness • Qualified principal residence indebtedness • Extended through 2012 per IRC sec. 108

10. Ordering of exclusions

11. Elections • 2 elections on timely filed return (including extensions) • Discharge of qualified real property business indebtedness – 108(c)(3) – part I of Form 982, line 1d • Apply reduction first against depreciable property – 108(b)(5) – part II of Form 982, line 5 • If missed, file amended return within 6 months of due date (excluding extensions) • Also an election to treat all real property held for resale as if it were depreciable property - part I of Form 982, line 3 Per Form 982, and instructions

12. Reduction of tax attributes • Different for – • Bankruptcy and Insolvency • Qualified principal residence debt • Qualified farm debt • Qualified real property business debt (election) per Pub 4681, starting on page 7

13. Reduction of tax attributes • For Bankruptcy and Insolvency - • General ordering rules for reductions • How much is reduced? Can be less than the canceled debt excluded from income. • Reductions are made after taxes for year are calculated • Need to reduce bases proportionally for property, held as of beginning of next tax year. per Pub 4681, page 7 and 8

14. Reduction of tax attributes • Other rules for – • Qualified principal residence debt • Basis of residence is reduced if still owned after cancellation • Qualified farm debt • Same as for Bankruptcy and Insolvency except there are different rules for basis reduction • Qualified real property business debt • Reduce basis of depreciable real property, held as of beginning of next tax year, unless disposed of earlier. per Pub 4681, pages 7, and 8-9

15. See the instructions to Form 982, page 2 • If discharged debt being excluded is • Qualified principal residence indebtedness • A non business debt, other than qualified principal residence indebtedness, such as a car loan or credit card debt, and • No other tax attributes listed in Part II (other than a basis in non depreciable property). • Only for a title 11 case or when insolvent • Any other debt

16. If there are disposals • Of secured assets - • Foreclosures and repossessions • Is taxpayer personally liable or not? • Abandonments • Is there a foreclosure or repossessionlater? • Of assets whose basis was reduced, it depends on which exclusion was used and when they were disposed of: • Same year or subsequent year • Also, there could be recapture of basis reductions under Bankruptcy and Insolvency rules

17. Reporting • On which tax return does this all wind up? • Depends on who the debtor is • Where could it go on the tax return? • Anywhere • Gets complicated if there are there splits • between personal • and business or rentals?

18. Canceled debts later repaid • If canceled debt is later repaid • May be able to file 1040X if the year the amount was included in income is still open per Pub 4681, page 3

19. IRS Guidance Prior to Pub 4681 May still be helpful

20. IRS Guidance Prior to Pub 4681 • IRS Pubs • 17 – federal income tax for individuals, chapter 12 (other income) • 525 – taxable and nontaxable income, COD under misc. income For exclusions • 908 – bankruptcy (and insolvency) • 225 – farmers, chapter 3 • 334 – small businesses (schedule C) chapter 5

21. IRS Guidance Prior to Pub 4681 • For qualified principal residence indebtedness - • IRS News Release IR 2008-17 • FAQs on IRS website • Instructions to revised Form 982 • Pub 523 – selling your home

22. IRS Guidance Prior to Pub 4681 • Other IRS Pubs • 544 – sales and other dispositions of assets: • chapter 1 for • Abandonments • and Foreclosures and Repo’s • and chapter 3 for depreciation recapture • 535 – business expenses (recapture) • 551 – basis of assets • Adjusted basis • Increases and decreases to basis

23. Form 982 Revised February 2008

24. Form 982 Part I

25. Form 982 Part I • Box 2 – amount excluded from gross income • Exclusion limitations for: • Qualified farm indebtedness • Qualified real property business indebtedness • Qualified principal residence indebtedness

26. Form 982 – Part II

27. Form 982 • Part II – • Reduction of tax attributes • Dollar for each dollar, in general • 33 1/3 cents for each dollar, for credits

28. Exclusions

29. Title 11 Bankruptcy Cases Exclusion – 108(a)1(A)

30. Definition - Title 11 case • A title 11 caseis a case under title 11 of the United States Code (relating to bankruptcy), • but only if the taxpayer is under the jurisdiction of the court in the case • and the discharge of indebtedness is granted by the court or is under a plan approved by the court. per Pub 4681, page 4 and Form 982 instructions

31. Title 11 bankruptcy cases • Chapter 12 – The chapter of the Bankruptcy Code providing for adjustment of debts of a "family farmer," as that term is defined in the Bankruptcy Code. http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter12.html • Chapter 13 – The chapter of the Bankruptcy Code providing for adjustment of debts of an individual with regular income, often referred to as a "wage-earner" plan. Chapter 13 allows a debtor to keep property and use his or her disposable income to pay debts over time, usually three to five years. http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter13.html

32. Title 11 bankruptcy casesIndividuals in Chapter 12 or 13 • A separate estate, for tax purposes, is not created for an individual who files a petition under Chapter 12 or 13 of the Bankruptcy Code. • Continue to file the same federal income tax return that was filed prior to the bankruptcy petition. • Do not include any debt canceled (because of bankruptcy) in income on individuals return. • However, they must reduce (to the extent that they have) certain losses, credits or basis in property by the amount of canceled debt. per Pub 908, page 2

33. Title 11 bankruptcy cases • Chapter 7 – The chapter of the Bankruptcy Code providing for "liquidation," that is, the sale of a debtor's nonexempt property and the distribution of the proceeds to creditors. http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter7.html • Chapter 11 – A reorganization bankruptcy, usually involving a corporation or partnership. A Chapter 11 debtor usually proposes a plan of reorganization to keep its business alive and pay creditors over time. People in business or individuals can also seek relief in Chapter 11. http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter11.html

34. Title 11 bankruptcy casesIndividuals in Chapter 7 or 11 • A separate “estate” is created consisting of property that belonged to the individual before the filing date. • This bankruptcy estate is a new taxable entity, completely separate from the individual taxpayer. • See page 4 of Pub 908 for list of attribute carryovers the estate gets • If later dismissed, file 1040X per Pub 908, page 2

35. Responsibilities of the individual debtor under Chapter 7 or 11 • The individual debtor, generally must file income tax returns during the period of the bankruptcy proceedings. • Do not include on those returns, the income, deductions, or credits belonging to the separate bankruptcy estate. • Also do not include as income on those returns, the 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. per Pub 908, pages 2 and 3

36. How to report the bankruptcy exclusion • Attach Form 982 to the respective federal income tax returns and check the box on line 1a. • Enter the total amount of debt canceled in the taxpayers title 11 bankruptcy case on line 2. per Pub 4681, page 4

37. How to report the bankruptcy exclusion • The taxpayer must also reduce their tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes later. per Pub 4681, page 4

38. Insolvency Exclusion – 108(a)1(B)

39. Insolvency • Do not include a canceled debt in income to the extent that the taxpayer was insolvent immediately before the cancellation. • They were insolvent immediately before the cancellation to the extent that the total of all of their liabilities exceeded the FMV of all of their assets immediately before the cancellation. per Pub 4681, page 4

40. Insolvency - liabilities • Liabilities include: • The entire amount of recourse debts, and • The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt. • Don’t forget taxes – • Income taxes • Property taxes • Sales taxes, if a business • Payroll taxes, if a business per Pub 4681, page 4,

41. Insolvency - liabilities • Examples in Pub 4681: • Credit card debt • Car loan • Student loan • What are some other examples? • Google financial statement forms • Banks and other lenders • Lawsuits and judgments

42. Insolvency - assets • Assets include the value of everything the taxpayer owns • including assets that serve as collateral for debt, • and exempt assets which are beyond the reach of their creditors under the law, such as their interest in a pension plan and the value of their retirement account. per Pub 4681, page 4

43. Insolvency - assets • Examples of other assets on page 7 of Pub 4681 • car at FMV • furniture at FMV • jewelry at FMV • savings account • What are some other examples? • Google financial statement forms • Banks and other lenders, e.g., John Deere’s, if farmer • Lawsuits and judgments • 1099 forms – indicators for financial assets

44. Fair market value • IRS definition • Not defined in Pub 4681 • Not defined in Pub 908 • Per Pub 551 Basis of Assets • FMV is the price at which property would change hands between a buyer and a seller, • neither having to buy or sell, • and both having reasonable knowledge of all necessary facts. • Also some guidance in Pub 526 for contributions of property http://www.irs.gov/pub/irs-pdf/p526.pdf

45. How to report the insolvency exclusion • Attach Form 982 to the taxpayer’s federal income tax return and check the box on line 1b. • On line 2, include the smaller of • the amount of the debt canceled • or the amount by which the taxpayer was insolvent immediately before the cancellation. per Pub 4681, page 4

46. How to report the insolvency exclusion • The taxpayer must also reduce their tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes later. per Pub 4681, page 4

47. Insolvency exclusion • See examples • on page 4 of Pub 4681 • Greg

48. Reduction of tax attributes for Bankruptcy and Insolvency

49. Bankruptcy and Insolvency • Reduction of tax attributes per IRS Pub 4681 • No tax attributes other than basis of personal use property • See Form 982 instructions, page 2 if discharged debt being excluded is • A non business debt, other than qualified principal residence indebtedness, such as a car loan or credit card debt per Pub 4681, page 7 and Form 982 instructions

50. Bankruptcy and Insolvency • Reduction of tax attributes per IRS Pub 4681 • All other tax attributes • General ordering rules • Exempt property under sec. 522 of title 11 – basis not reduced, per Pub 908, page 23 per Pub 4681, pages 7 and 8