Cancellation of Indebtedness
If an individual or business borrows money from a creditor (i.e. mortgage lenders, credit card companies, etc.) this does not give rise to any income tax liability because the individual or business has an obligation to repay that money. If the debt is then forgiven or cancelled, this taxpayer then has incurred cancellation of indebtedness income because their obligation to repay that money has been removed.
The failure of a lender to pursue payment does not automatically constitute forgiveness of indebtedness. When a lender cancels any indebtedness, I.R.C. § 6050 requires the lender to issue Form 1099-C and submit to the IRS and the taxpayer if the indebtedness is greater than $600. The mere receipt of a 1099-C by the taxpayer does not mean that they have recognized income. The lender could have issued an erroneous 1099-C or a statutory exclusion could apply to remove the cancellation if indebtedness income from the taxpayer’s gross income.
Rules and Requirements
Cancellation of Indebtedness
I.R.C. § 61(a):
“…gross income means all income from whatever source derived, including (but not limited to) the following items:
… (12) Income from discharge of indebtedness”
Treasury Regulation § 1.61-12 “Income from discharge of indebtedness”
(a) The discharge of indebtedness, in whole or in part, may result in the realization of income.
Where indebtedness is being discharged, the resulting income would equal the difference between the amount due on the obligation and the amount paid, if any, for the discharge. Martin v. Commissioner of Internal Revenue, T.C. Summ.Op 2009-121, 2009 WL 2381577 (U.S. Tax Ct. 2009).
I.R.C. § 108(a). Exclusion from Gross Income.
Gross income does not include any amount which would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if:
- the discharge occurs in a title 11 case
- the discharge occurs when the taxpayer is insolvent
- the indebtedness discharged is qualified farm indebtedness
- in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
- the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010.
I.R.C. § 108(d)(1) defines “Indebtedness of taxpayer:”
For purposes of this section, the term ‘indebtedness of the taxpayer’ means any indebtedness:
- for which the taxpayer is liable, or
- subject to which the taxpayer holds property.
Insolvency, I.R.C. § 108(a)(1)(B)
I.R.C. § 108(a)(3) insolvency exclusion limited to amount of insolvency.
In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.
I.R.C. § 108(d)(e) defines “insolvent”:
For purposes of this section, the term ‘insolvent’ means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before discharge.
Bankruptcy Exclusion, I.R.C. §108(a)(1)(A)
I.R.C. § 108(d)(2):
The term “title 11 case” means 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 such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.
A discharge that occurs in either a Chapter 7 or Chapter 13 bankruptcy is excluded from a taxpayer’s income. Proof that the indebtedness was actually discharged in the bankruptcy is required. Student attorneys should obtain a copy of the taxpayer’s bankruptcy schedules, and verify on the taxpayer’s PACER report that the bankruptcy discharge actually occurred.
Qualified Principal Residence Indebtedness, I.R.C. § 108(a)(1)(E)
I.R.C. § 108(h):
(h) Special rules relating to qualified principal residence indebtedness:
- (1) Basis Reduction
- The amount excluded from gross income by reason of subsection (a)(1)(E) shall be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer.
- (2) Qualified principal residence indebtedness
- For purposes of this section, the term “qualified principal residence indebtedness” means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting “$2,000,000 ($1,000,000″ for “$1,000,000 ($500,000″ in clause (ii) thereof) with respect to the principal residence of the taxpayer.
- (3) Exception for certain discharges not related to taxpayer’s financial condition.
- Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.
- (4) Ordering rule
- If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.
- (5) Principal residence
- For purposes of this subsection, the term “principal residence” has the same meaning as when used in section121.
(B) Acquisition indebtedness
- (i) In general the term “acquisition indebtedness” means any indebtedness which
- (I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and
- (II) is secured by such residence.
Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.
- (ii) $1,000,000 limitation. The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).
Summary from Publication 4681 (p. 6):
For taxable years ending prior to December 31, 2013, a taxpayer is permitted to exclude canceled debt from income if it is qualified principal residence indebtedness by filing Form 982. Qualified principal residence indebtedness is any debt incurred in acquiring, constructing, or substantially improving your principal residence and which is secured by your principal residence. Qualified principal residence indebtedness also includes any debt secured by your principal residence resulting from the refinancing of debt incurred to acquire, construct, or substantially improve your principal residence but only to the extent the amount of debt does not exceed the amount of the refinanced debt.
There are currently eight factors the lender should take into account when considering whether to file a Form 1099-C that are listed in the regulations under section § 6050. The eigth factor is the 36 month nonpayment testing period. Practitioners convinced Treasury that this factor created confusion because it was an arbitrary time period. After several decades, Treasury has issued proposed regulations to eliminate that factor. Below is a copy of the proposed regulation and a summary of the regulation. The comment period expires on January 13, 2015. As a clinic student attorney you will not often deal with § 6050.
Making Your Case
The most important aspect of any cancellation of indebtedness case is to gather accurate facts of the taxpayer’s case. Student attorneys should determine whether any debt has been cancelled and whether the taxpayer was insolvent immediately prior to any cancellation. Clinic investigative tools such as Accurint, GSCCA, and P.A.C.E.R. should be utilized. The taxpayer should be thoroughly interviewed about the indebtedness, and the creditor should be contacted. Some items to consider during your investigation are:
- How much did the taxpayer owe at the time of cancellation?
- Is the loan secured to property?
- If the loan is securitized, what happened with that property? Was it foreclosed on or abandoned?
- What was the value of that property at the time of cancellation?
- What year was the loan cancelled?
After a sufficient factual basis has been developed by the student attorney, as many defenses as possible to the cancellation of indebtedness income should be prepared. Some of the successful defenses used by other student attorneys are summarized below.
Disputing the sufficiency of the 1099-C
Many 1099-Cs issued by lenders have contained incorrect information or have left off necessary information. When the cancellation of indebtedness income arises from a car loan, a mortgage, or any other securitized debt, the lender must report the fair market value used to make their calculations on either the 1099-C, or a 1099-A. Student attorneys have been successful in challenging the fair market value listed by the lender.
Student attorneys should always contact the lender and try to get as much information as possible from the lender about why they reported the figures they did. Sometimes lenders will be nonresponsive, or not have records, and this circumstantial evidence can be used in making the taxpayer’s case.
In general, the IRS’s determination in a notice of deficiency is presumed correct, and the burden is on the taxpayer to prove otherwise. Tax Court Rule 142; Welch v. Helvering, 290 U.S. 111, 11 (1933). However, under certain circumstances the burden may shift where a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the income tax liability of the taxpayer. IRC § 7491(a)(1). Additionally, IRC § 6201(d) provides that in any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return, such as a Form 1099-C, and the taxpayer has fully cooperated with the IRS, the IRS has the burden of producing reasonable and probative information concerning the deficiency in addition to the information on the information return.
In Martin v. Commissioner a taxpayer disputed the fair market value of a repossessed vehicle reported by the lender on its 1099-C. The taxpayer testified in court that the value was incorrect because the fair market value of the vehicle was higher at the time of repossession, which occurred three years before the issuance of the 1099-C. The burden to prove the sufficiency of the 1099-C then shifted to the IRS, and they subsequently were unable to disprove the taxpayer’s testimony. Martin v. Commissioner of Internal Revenue, T.C. Summ.Op 2009-121, 2009 WL 2381577 (U.S. Tax Ct. 2009).
This case is illustrative of a defense that can be used by student attorneys in the Clinic. If a student attorney can assert a reasonable dispute to the fair market value listed on the lender’s 1099-C or 1099-A, then the burden will shift to the IRS to prove the 1099 is correct. If the IRS cannot prove this figure is correct, or dispute the taxpayer’s claims, the taxpayer will likely win their argument.
Real Property Valuations
Foreclosure deeds (which can be found on GSCCA), county property tax assessment values (found on Accurint or the County’s website), and comparable property sales (found on http://homesales.ajchomefinder.com/homesales) all can be used to dispute the fair market value assigned to real property by a lender. What a vehicle was worth in a certain year, or its historical value, can be established with a service on Edmunds.com (http://support.edmunds.com/faq-Historical-True-Market-Value-TMV-499.aspx).
If the foreclosure sales price differs from the amount reported by the lender, one could argue that the foreclosure sales price is the correct fair market value because it represents what a buyer is willing to pay in the marketplace.
Treasury Regulation § 1.166-6(b) addresses the fair market value for the sale of mortgaged or pledged property by a lender. Treas. Reg. § 1.166-6(b) “Realization of gain or loss” states:
(1) “Determination of amount” – If, in the case of a sale described in paragraph (a) of this section, the creditor buys in the mortgaged or pledged property, loss or gain is also realized, measured by the difference between the amount of those obligations of the debtor which are applied to the purchase or bid price of the property and the fair market value of the property.
(2) “Fair Market value defined.” – The fair market value of the property for this purpose shall, in the absence of clear and convincing proof to the contrary, be presumed to be the amount for which it is bid in by the taxpayer.
Usually lenders bid in the foreclosed property the amount they are owed. If a fair market value is not reported on the 1099-C (which would qualify as “clear and convincing proof”), the taxpayer can claim the amount bid in by the lender is the fair market value and will likely remove their cancellation of indebtedness income. Even if a fair market value is reported on the 1099-C by the lender, one could still argue it is not “clear and convincing proof” if the student attorney has their own facts or property values to dispute the lender’s figure.
Debt cancelled in wrong year
I.R.C. § 451 and Treas. Reg. § 1.451-2 provide that an item of gross income is includable in the year the income is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer could have drawn upon the amount during the taxable year. Student attorneys have argued that the lender issued their 1099-C in the wrong tax year because the debt was actually cancelled in a prior tax year. This argument should be used in conjunction with another exclusion or defense, since it only reflects on the poor accounting practices of the lender and not whether the taxpayer actually had income.
Insolvency is a statutory exclusion to cancellation of indebtedness income contained in I.R.C. § 108(a)(1)(B). A taxpayer is insolvent to the extent that their liabilities exceed the fair market value of their assets. I.R.C. § 108(d)(e). Cancellation of indebtedness income can be excluded to the extent that the taxpayer is insolvent. I.R.C. § 108(a)(3).
Student attorneys should obtain their client’s credit report and the client should be interviewed about what assets (home, vehicles, bank accounts, personal property, etc.) and liabilities (mortgage, credit card debt, loans, etc.) he or she has. A free credit report can be obtained from https://www.annualcreditreport.com/cra/index.jsp.
If the insolvency exclusion is asserted in any memorandum to the IRS, a chart showing the taxpayer’s assets and liabilities should be included for clarity.
|Home FMV:||$46,000||Home Loan||$ 102,888|
|Personal Possessions:||$ 4,100||Car Loan||$ 1,633|
|1. Vehicle:||$ 3,500||Credit Card Debt||$ 8,785|
|2. Vehicle:||$ 400||Utilities Debt||$ 584|
|3. Home Furnishings||$ 90||Outstanding Tax Liab.||$ 2,830|
|4. Clothing||$ 70||Accounts Debt.||$ 4,340|
|5. Cash||$ 30||Communication Debt||$ 400|
|Total Assets||$ 58,190||Total Liabilities||$121,460|
|Total Insolvency||($ 67,270)|
Disputed Debt Doctrine
The court in Zarin v. Commissioner stated: “Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the mount of debt cognizable for tax purposes.” Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990). The difference between the original debt and the settled debt is then not considered cancellation of indebtedness income.
This doctrine can also be used in conjunction with I.R.C. § 108(d). I.R.C. § 108(d) defines the term “indebtedness of the taxpayer” (as the term is used in I.R.C. § 108) as “any indebtedness: (A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property.” A student attorney can argue that if a taxpayer is disputing, in good faith, the amount of the debt they owe and a settlement has not been reached, then the taxpayer is not liable as for the tax liability pursuant to Zarin and I.R.C. § 108(d) since they are not liable for the debt.
Understanding the Mortgage Forgiveness Debt Relief Act of 2007 and its implications
Outline prepared by Frances D. Sheedy, Esq. ABA Tax Section, Pro Bono Committee, 5-8-2008
Publication 4681 - Canceled Debts, Foreclosures, Repossessions and Abandonments.
Form 982 - Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)