Generally speaking, the discharge of indebtedness yields income to the recipient. However, in following instances, no income is recognized;
>Gross income does not include discharge of indebtedness if the discharge occurs in a Title 11 bankruptcy case. To qualify for the exclusion under this provision, the taxpayer must be under the jurisdiction of the Bankruptcy Court and the discharge must be granted by the Court or be pursuant to a plan approved by the Court.
>Discharge of indebtedness is also not included in gross income to the extent the taxpayer is insolvent. The taxpayer is insolvent to the extent the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets immediately before the discharge of indebtedness;
>Qualified real property business indebtedness is indebtedness a taxpayer incurs or assumes in connection with real property used in a trade or business. The indebtedness must also be secured by the real property and have been incurred or assumed before January 1, 1993, or qualify as acquisition indebtedness. A refinancing of such debt qualifies as long as the debt incurred upon refinancing does not exceed the amount of the refinanced debt. Qualified acquisition indebtedness includes any indebtedness incurred or assumed to acquire, construct, or substantially improve real property used in a trade or business.
This exclusion from gross income is limited to the outstanding principal amount of such indebtedness over the fair market value of the qualified real property less the outstanding principal amount of any other qualified real property business indebtedness secured by the property. This exclusion from gross income is further limited to the aggregate adjusted bases of all of the taxpayer’s depreciable real property held by the taxpayer immediately before the discharge other than depreciable real property acquired in contemplation of the discharge.
Example 1. Albert owns a business building in an area in which real estate values have declined substantially. His business building now has a fair market value of $80,000 and an adjusted basis of $25,000. The building is subject to a first mortgage loan obtained in 1988 that is qualified real property business indebtedness. The current balance on this first mortgage loan is $100,000. There is also a second mortgage loan on this building in the amount of $15,000 that is also qualified real property business indebtedness. Albert owns no other depreciable real property. The first limitation on the maximum amount Albert may exclude from his gross income for discharge of indebtedness is $35,000 [($100,000 + $15,000) – ($80,000)]. The maximum amount Albert may exclude, however, is limited further to $25,000–his aggregate adjusted bases in all his depreciable real property.
>If a seller discharges a debt that arose from the purchase of property, the discharge of the liability is excluded from gross income. The debtor must reduce the basis of the asset purchased by the amount of the liability discharged. This provision does not apply in the case of a debt discharged in a Title 11 bankruptcy or if the taxpayer is insolvent
>Gross income does not include amounts under the discharge of qualified farm indebtedness. Qualified farm indebtedness must have been incurred directly in connection with the taxpayer’s trade or business of farming. Also, 50% or more of the taxpayer’s gross receipts for the three taxable years before the taxable year of the discharge must be attributable to the trade or business of farming.
To qualify for this exclusion, a qualified person must make the discharge of the taxpayer’s indebtedness. A qualified person is any person actively engaged in the business of lending money or any governmental agency or instrumentality. The person must not be related to the taxpayer. In addition, the taxpayer must not have acquired the property from the person or a person related to the person. Finally, the person must not receive a fee with respect to the taxpayer’s property or be related to such a person.
>Gross income does not include the value of any property received by gift. If there is a business purpose for a voluntary discharge of the indebtedness of a family member, the debtor will likely be unsuccessful in excluding such a discharge as a gift. The most likely case of exclusion of discharge of indebtedness from gross income as a gift would be a discharge of a debt owed to a family member solely for personal purposes.
>Gross income, however, does not include any debt discharged under the provisions of a student loan in which the individual is discharged of part or all of such loan for working for a certain period of time in certain professions.
>When a corporation exchanges its indebtedness to a shareholder for a contribution to capital, the corporation will be deemed to have satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness.
The shareholder will recognize no gain or loss on the exchange. The shareholder would be deemed to have made a contribution to the corporation’s capital for which the shareholder would receive basis. The corporation will recognize gross income from the discharge of indebtedness only to the extent the corporation’s book balance of the debt exceeds the shareholder’s adjusted basis in the debt. This income would be excluded from the corporation’s gross income if the corporation is insolvent or is in a Title 11 bankruptcy case.
Example 5. Etter Corporation issued a $20,000 note to shareholder Baker. At a time when the balance on the note is $18,000, Baker sells the note to shareholder Carlton for its fair market value of $16,000. Carlton has an adjusted basis in the note equal to its $16,000 cost. Then Carlton forgives the debt as a contribution to Etter Corporation’s capital at a time when Etter Corporation is solvent and not in a Title 11 bankruptcy case. Etter Corporation is deemed to have paid the debt with an amount of money equal to Carlton’s $16,000 adjusted basis. Carlton recognizes no gain or loss. Etter Corporation recognizes $2,000 gross income for the excess of the book balance of the note over the amount of the deemed payment ($18,000 $16,000).
If the shareholder forgave the debt in consideration for goods or services provided to him by the corporation, however, the corporation would recognize gross income;
>The debtor excludes discharge of indebtedness from gross income to the extent the payment of the debt would have given rise to a deduction;
>A taxpayer must include discharge of liabilities in determining the amount realized on a sale or exchange of property unless the discharge is considered income from discharge of indebtedness under IRC Sec. 61(a)(12). Another exception to including discharge of liabilities in the amount realized exists if the taxpayer incurred the liabilities discharged on the acquisition of the property, but such liabilities were not included in determining the basis of the property.
If the liability discharged is a recourse liability and it exceeds the fair market value of the property exchanged, the amount realized on the exchange is limited to the fair market value of the property. However, the difference between the amount of liabilities discharged and the fair market value of the property must be included in gross income as income from discharge of indebtedness unless excluded by another IRC section.
Example 2. Betty owned a personal residence with a basis of $60,000 and a fair market value of $55,000. Betty is solvent, but she owes $70,000 on a mortgage loan secured by the property and for which she is personally liable. Betty deeds the property back to the mortgagee and the mortgagee forgives the mortgage note. Betty is deemed to have sold the residence for $55,000. Thus, Betty has realized a $5,000 loss on the exchange ($55,000 $60,000). Because the loss is on personal use property, the loss is not deductible. Betty must recognize $15,000 gross income from discharge of indebtedness ($70,000 $55,000).
Example 3. Assume the same facts as in Example 2 except the fair market value of the residence is $67,000. Betty is deemed to have sold the residence for $67,000. Thus, Betty has to recognize a $7,000 long-term capital gain ($67,000 – $60,000), unless she meets the criteria for deferral of the gain under IRC Sec. 1034. Betty also must recognize $3,000 gross income from discharge of indebtedness. This $3,000 is not eligible for deferral under IRC Sec. 1034.
If the liability discharged is a nonrecourse liability, then the full amount of the liability discharged is included in the amount realized on the sale or exchange of property. This applies even if the amount of the nonrecourse liability is greater than the fair market value of the property;
THIS SHOULD NOT BE DEEMED TO BE LEGAL OR TAX ADVICE BUT IS FOR INFORMATIONAL PURPOSES ONLY. PLEASE CONSULT YOUR LOCAL TAX PROFESSIONAL.