Income And Cancellation of Bank Debt

 

There is a basic presumption in the tax Code that any accession to “wealth” is income. It isn’t much of a leap for the tax Code to then say that all income is taxable unless otherwise excluded.

Let’s next look at “wealth.” I propose a working definition as follows:

          Assets (A) = Liabilities (L) + Wealth (W)

A little algebra shows the following:

          A – L = W

Here is spiff on the above: do you have wealth if your liabilities go down?

Let’s look at the Katrina White case.

Katrina started a business in 2015. She took out a business loan for $15,000. She leased space for her business, signing a three-year lease.

The business did not work out. The family lent her $8 grand, but there was no way to save it. She had repaid the bank less than a grand when her remaining debt of $14,433 was discharged. The bank sent her a 1099, of course, as all American life events can apparently be reduced to a 1099.

Katrina never made a payment on the lease. Since rent was late for more than two months, the entire lease became due and payable. That fiasco totaled $21,700.

 She filed her return.

The IRS said she left out income of $14,433.

How?

Let’s go through it.

Katrina said that her wealth (that is, A – L = W) was as follows when the business failed:                 

Real property		28,500
Personal property		3,560
		32,060
Student loans		5,294
Utilities		961
Utilities, estimated		2,500
Furniture loan		1,120
Judgements		8,128
Bank loan		14,433
Lease breach		21,700
Family loan		7,800
		61,936
Net wealth		(29,876)

The IRS wasn’t buying this. They argued that:

·      The estimated utilities were a no go.

·      The family loan wasn’t really a “loan.”

·      While we are at it, the lease breach wasn’t really a loan, as the landlord had no intention of enforcing the debt.

The IRS math was as follows:

Real property		28,500
Personal property		3,560
		32,060
Student loans		5,294
Utilities		961
Furniture loan		1,120
Judgements		8,128
Bank loan		14,433
		29,936
Net wealth		2,124

The matter went to Tax Court.

The Court pointed out the obvious: Katrina signed a valid and binding lease contract. Perhaps the landlord decided that there was nothing there to pursue, but it cannot be argued that she had an enforceable debt.

The Court saw the following:

Real property		28,500
Personal property		3,560
		32,060
Student loans		5,294
Utilities		961
Furniture loan		1,120
Judgements		8,128
Bank loan		14,433
Lease breach		21,700
		51,636
Net wealth		(19,576)

Let’s recap our numbers:

Wealth per Katrina was          ($29,876)

Wealth per the IRS was              $2,124

Wealth per the Court was        ($19,576)

Remember what we said at the beginning, that all income is taxable unless there is an exception?  Well, there is an exception for cancellation of debt. Several, in fact, but today we are concerned with only one: insolvency. The Code says that one does not have income to the extent that one is insolvent.

What is insolvency?

Go back to the formula: A – L = W.

To the extent that “W” is negative, one is insolvent. Another way of saying it is that one has more debts than assets.

So, who showed negative “W”?

Well, Katrina did. So did the Court.

Katrina was insolvent. That was an exception to cancellation of indebtedness income. Katrina did not have taxable income. The IRS lost.

Our case this time was Katrina White v Commissioner, T.C. Memo 2023.-77.

TurboTax and Penalties

I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000

          The mortgage is             $270,000

          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000

          The house cost               (290,000)

          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000

          The house is worth        (215,000)

          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:

§ 108 Income from discharge of indebtedness.

(a)  Exclusion from gross income.

(1)  In general.

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-

(i)  before January 1, 2018, or

(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000

          The house cost               (290,000)

          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.

COMMENT: There was enough here to use a tax professional.

They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:

This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”

Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.

… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”

They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.

Can You Have Cancellation Of Debt Income If You Are Still Paying On The Debt?

Harold is a native Hawaiian. He has worked in the telecommunications industry for more than 40 years. In 1996 he founded Summit Communications, Inc (Summit), which he served in the capacity of president, chief executive officer and director.

Al has a background similar to Harold's, but his company was called Sandwich Isles Communications, Inc (SIC). In 1997 he desperately needed a telecommunications executive. Al met Harold and wanted Harold to come work for him.

Harold was already involved with Summit, which was having business issues. Harold felt a commitment to the company and his employees.

But Al was not going to let go easily.

In 1998 Al sweetened the offer by including a $450,000 loan. He knew that Harold would immediately loan the monies to Summit. In fact, that is why Al offered the deal. He wanted to loan to be to Harold so that he and SIC did not have to deal with Summit's board of directors.

SIC also wanted to contract with Summit for operations and technical support.

Harold signed on with SIC, and Al let him stay on as Summit's director and chief executive officer.

They signed a note, stipulating that Harold had to repay the loan if he ever left SIC's employment.

The relationship went well, and by the end of 1999 Summit was booming, although - granted - SIC represented 60% of its revenues. It was growing so much that it need Harold back. Al, basically being a good guy, agreed that Harold should return.

No one remembered that Harold had to repay the loan.

SIC then received a large loan from the U.S. Department of Agriculture, which it used to upgrade its operations and technical staff. As it did, SIC's reliance on Summit decreased. By 2002 Summit filed a bankruptcy petition. By 2005 Harold had gone back to work for Al.

In 2010 the IRS audited SIC.

In 2011 Al met with Harold and reminded him that the loan was still due. Harold arranged for payroll deductions - first for $300 per month, then $600 and finally a $1,000 a month - to repay the loan.

The IRS sent a notice to Harold. The IRS said that SIC had discharged his loan, and he had cancellation of indebtedness income.

Think about this for a moment. The IRS wanted taxes from Harold because he had been let off the hook for a $450,000 loan. The problem is that Harold was still paying on the loan. Both cannot be true at the same time, so what was the IRS' reasoning?

It primarily had to do with how many years SIC had to pursue collection before the statute of limitations ran out. Remember: Harold did not start paying the loan until 2011. According to the IRS, there was no enforceable loan at that time, as SIC had gone too long without any evident collection activity. That was the triggering event for income to Harold: when the debt was no longer enforceable.

The IRS had a good point.

The IRS also argued that Harold starting repaying on the loan because it had noticed the defaulted loan on audit and Harold did not want to pay taxes on it.

Harold and Al appeared before the Court and testified that they both considered the loan outstanding, and the Court found them both to be "honest, forthright, and credible."

The Court could not help but notice that Harold and Al were on separate sides with respect to the loan.

 ... respondent argues that any repayment activity taken after the commencement of the examination should be discounted. We disagree. The testimony suggests instead that [Harold] sought to repay the SIC loan because he understood that it was his obligation to repay it. Additionally, a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against [Harold's] economic interests."

The Court agreed that cancellation of income requires a triggering event, but it disagreed that the expiration of the statute automatically rose to that level.

... the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor."

The Court decided that Harold owed the debt. He did not have income.

Why did the IRS pursue this? It certainly did not put a smiley face on their public persona.

I suspect the IRS considered themselves backed into a corner. If the loan really was uncollectible AND the IRS did not pursue, then the regular three-year statute on tax assessments would close on Harold's tax year. At that point, the IRS could not reach Harold again if it wanted to. If however the IRS went to Court - even if it lost - it would mean that the loan was either still in place or discharged in a later year. In either case, the IRS could reach Harold.

Credit Card Debt And Yankee Doodle Dandy

There is a tax doctrine known as the Cohan rule. It is named after the American composer and playwright George M. Cohan, the subject of the movie Yankee Doodle Dandy. While a renown musician, composer and playwright, he was not much of a recordkeeper, and he found himself in front of the Court defending his business expenses against challenge by the IRS. The Court took an extremely friendly stance and allowed him to estimate his deductions.

While the Cohan rule still exists (in some capacity) today, it should be noted that the tax Code has been changed to disallow the next George Cohan any tax deduction for estimated meals, travel and entertainment. Those particular deductions have to be substantiated or no deduction will be allowed, with or without a friendly judge.

I just read a case where (I believe) a variation on the Cohan rule came up.

The case has to do with cancellation of indebtedness income.

Did you know you could be taxed if a credit card company forgives your balance?

The reason is that the tax Code considers an "accession to wealth" to be "income" (with exceptions, of course). Take the conventional definition of wealth as 

... assets owned less debts owed ...

and you can see that the definition has two moving parts. The asset part is easy - your paycheck increases your bank account, if only fleetingly. The liability part in turn is the reason you can borrow money and not have it considered income (assets and liabilities increase by the same amount, so the difference is zero). Have the bank forgive the debt, however, and the difference is no longer zero.

Newman did something odd. He wrote a check on his Wells Fargo account and opened a new account at Bank of America. He withdrew money from the new account. Meanwhile the check on Wells Fargo bounced.

Bank of America wanted its money back. Newman did not have it anymore.

Impasse.

You may know that a bank will issue a Form 1099 (Form 1099-C, specifically) when it cancels a debt. That 1099 informs the IRS about the forgiveness, and it is a heads-up to them to check for that income on your tax return.

            Question: when does the the bank issue the 1099?

In general it will be after 36 months of inactivity. Newman bounced the check in 2008 and received the 1099 in 2011.

Newman left the 1099 off his tax return. The IRS put it back on.

The Court decided Newman had - potentially - income in 2011.

Newman fired back: he did not have income because he was insolvent in 2011, and the tax Code allows one to avoid debt income to the extent one is insolvent.

You and I use another word for "insolvent" in our day-to-day conversation:  bankrupt.

Bankrupt means that you owe more than you are worth. The tax Code has an exception to debt income for bankruptcy, but it only applies if one is in Bankruptcy Court. But what if you are trying to work something out without going to Bankruptcy Court? The Code recognizes this scenario and refers to it as "insolvency."

So Newman had to persuade the Court that he was insolvent.

One would expect him to bring in a banker's box of bank statements, credit card bills, car loan balances and so forth to substantiate his argument.

The Court looked and said:

At trial petitioner provided credible testimony that his assets and liabilities were what he claimed they were."

"Testimony?"

What about that banker's box?

Newman ran a Hail Mary play with time expiring on the game clock. While a low-probability play, he connected for a touchdown and the win.

To a tax advisor, however, Newman was decided differently from Shepherd, another Tax Court case from 2012 where the taxpayer needed much more than his testimony to substantiate his insolvency.

Why the difference between the two Court decisions?

With that question you have an insight into the headaches of professional tax practice.

What Does Insolvency Mean To The IRS?

Shepherd v Commissioner is a pro se case before the Tax Court. “Pro se” means that the taxpayer is representing himself/herself, without a professional. Technically that is not correct, as a taxpayer can go into Tax Court with a professional and still be considered “pro se.” This happens if the professional (say a CPA) has not passed the examination to practice before the Court. The CPA can then “advise” but not “practice,” and the taxpayer is considered “pro se.”

Today we will be talking about cancellation-of-debt income. Tax pros commonly refer to this is “COD” income. For many years I rarely saw a COD issue. In recent years it seems to be endemic. There are two common ways to generate COD: a home is foreclosed or a credit card is settled. If one pays less than the balance of the debt, the remaining balance is considered to be income to the debtor.

How can that be, you may ask. Let’s use an example. Say you go to your bank and borrow $50,000. When the loan is due, you cannot afford to pay in full. The bank agrees to accept $36,000 as full payment on the loan. From the IRS’ perspective, you received and kept a net $14,000. Perhaps you bought a car, went on vacation, or paid for a kid’s college, but you had an accession to wealth. The IRS considers the $14,000 to be income to you.

There are exceptions, and Shepherd involves the “insolvency” exception. This is different from the bankruptcy exception. Granted, in both cases you are likely insolvent, but for the insolvency exception you do not have to file with a bankruptcy court.

Let’s quickly take a look at the wording for insolvency in the tax code:

   108(d)(3) 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 the discharge.

An easy way to understand insolvency is the following formula:

·        Add the fair market value of everything you own, then

·        Subtract everything you owe

If the result is negative, you are insolvent. You owe more than you own. You are negative or upside-down. There are special rules for assets such as a pension, but you get the concept.

The IRS says that – if you are insolvent – then COD income not be taxable to you to the extent you are insolvent. Let’s use numbers to help understand this:

·        You own $160,000

·        You owe $175,000

·        Visa forgives $22,000

Your COD income is $22,000 (what Visa forgave).

Your insolvency is $15,000 (175,000 – 160,000).

Therefore $7,000 of your COD income (22,000- 15,000) will be taxable to you. The rest is not taxable.

The tax law requires you to do the calculation of what you own and what you owe as of the date the debt is forgiven. It is not two years later or 18 months before. Remember: this is tax law not a tax suggestion.

Let’s swing over to Shepherd. He and his wife lived in New Jersey and owed Capital One Bank approximately $10,000. In 2008 they settled for approximately $5,500, leaving COD income of $4,500.

The Shepherds claimed insolvency and did not report the $4,500 as 2008 income. The IRS looked into it and found that the key to the insolvency calculation was the value Shepherd attached to two houses.

The first was his beach house. Shepherd received a property assessment of $380,000 for the 2010 tax year. He appealed the assessment, claiming a value closer to $340,000. He presented this as evidence before the Court. The Court had two immediate issues:

·        There is a long-standing tax doctrine that the value of property for local tax purposes is not determinative of fair market value for federal income tax purposes. This is the Gilmartin case, and it clearly established the tax code’s preference for an appraisal over property tax bills.

·        Shepherd did not present to the Court the methodology, procedures or analysis, including comparable sales, for thinking that the value was closer to $340,000. At that point it was just an opinion, and the Court was not bound by his opinion.

The Court pointed out that these events took place two years after the debt forgiveness and said fuhgeddaboudit to Shepherd’s valuation of the beach house.

The second was his principal residence.

·        Shepherd showed the Court a tax bill. The Court duly dismissed that under the Gilmartin doctrine.

·        Shepherd applied for a loan modification in 2011. Chase Home Finance showed a value of $380,000 in a modification letter. The Court wasn’t buying into this, noting that Chase’s letter did not show any analysis or procedures used in arriving at value, such as comparable sales. That is, it was not an appraisal. Oh, and by the way, the letter was three years after the debt discharge.

What is a tax pro’s take? Folks, Shepherd had virtually no leg to stand on. How can one read the tax code stating “immediately before the discharge” and reason that three years later – and after one of the worst housing markets in U.S. history – would constitute “immediately before”? This is simply not reasonable. You are going to lose this if challenged by the IRS. Shepherd’s position is so preposterous that I suspect he was truly “pro se” and did not have a professional, either when he prepared his return or when he was presenting his arguments in Court.