Income And Cancellation of Indebtedness

 

I am reading a case about cancellation of indebtedness income. 

Let’s take a moment to discuss the concept of income in the tax Code. 

The 16^th amendment, passed in 1913 and authorizing a federal income tax, reads as follows: 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Needless to say, the definition of “incomes, from whatever source” became immediately contentious. 

Ask a tax practitioner for a definition of income, and it is likely that he/she will respond with “an accession to wealth.” 

That phrase comes from a 1955 Supreme Court case (Commissioner v Glenshaw Glass) which included the following: 

Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." 

I am seeing three conditions, of which “accession to wealth” is but one. 

Let’s circle back to indebtedness and income.

Can one have income by borrowing money? 

Unless there is something extraordinarily odd about the loan, I would say “no.” The reason is that any increase in wealth (by receipt of the loan proceeds) is immediately offset by the requirement to repay the loan. 

Let’s say you buy a house. You take out a mortgage. 

What if you are in financial distress and mail the keys back to the mortgage company? 

Granted, the house secures the debt, but surrendering the house does not automatically release the debt. It however will likely result in your receiving the following 1099:

Like any 1099, there is a presumption of income. In this instance, there has been an exchange in the ownership of the house. There is another way to say this: the tax Code sees a sale of the property. 

It seems odd that tax sees potential income here. It is unlikely to happen if the surrendered asset is one’s principal residence, as one would have access to the $250,000/$500,000 gain exclusion. It could happen if the surrendered asset is rental or investment property, though. 

What about the debt on the property? 

Tax considers that a separate transaction. 

When the debt is discharged, the IRS has yet another form: 

Yes, it gets confusing. The system works much better when the two steps happen concurrently – such as in a short sale. In that case, it is common to skip the 1099-A altogether and just issue the 1099-C. 

NOTE: There is a twist in the straw depending upon whether the debt is recourse or nonrecourse. Believe it or not, there are about a dozen states where you can buy your principal residence with nonrecourse debt. You will not be surprised to learn that California is one of them. The upside is that you can return the keys to the bank and no longer be responsible for the mortgage. The downside is this policy was a major contributor to the burst of the housing bubble in the late aughts.

It is common for the 1099-C to be issued three years after the 1099-A. Why? The Code requires the reporting of cancellation of indebtedness on or before an “identifiable event” happens. 

An identifiable event in turn is defined as: 

1.  bankruptcy
2.  expiration of statute of limitations for collection
3.  cancellation of debt that renders it unenforceable in a receivership, foreclosure, or similar proceeding
4.  creditor's election of foreclosure remedies that statutorily bars recovery
5.  cancelation of debt due to probate proceedings
6.  creditor's discharge pursuant to an agreement
7.  discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt
8.  in specific cases, the expiration of a non-payment testing period [presumption of 36 months of no payment to the creditor]    

The three years is number (8). 

The income type we are discussing with the 1099-C is cancellation of indebtedness income. As discussed, just borrowing money does not create income. Whereas your assets may go up (you have cash from the loan or bought something with the cash), that amount is offset by the loan itself. The scales are balanced, and there is no accession to income. 

However, cancel the debt. 

The scale is no longer balanced. 

Meaning you have potential income. 

But the Code allows for exceptions. Here is Section 108: 

                (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—

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

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

(i) before January 1, 2026, or

(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2026. 

The common ones are (a)(1)(A) for bankruptcy and (a)(1)B) for insolvency. 

Bankruptcy is self-explanatory. 

Solvency is not self-explanatory. You can think of insolvency as being bankrupt but not filing for formal bankruptcy. You owe more than you own. Let’s call the difference between the two the “hole.” To the extent that that cancelled debt is less than the “hole,” there is no cancellation of indebtedness income. Once the cancelled debt equals the “hole,” the exclusion ends. At that point, your net worth is zero (-0-). Technically the next dollar is an “accession to wealth” and therefore income. 

In our case this week Ilana Jivago borrowed from Citibank. She defaulted and was eventually foreclosed on in 2009. Citibank sent her a 1099-C. Jivago argued that it was nontaxable because it was qualified principal residence indebtedness per (a)(1)(E) above. 

Qualified principal residence indebtedness is defined as:         

Indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.

The Court looked at photographs of and admired the renovations she made in 2005 and 2006. The Court noted that Jivago did not use an interior designer, and she did much of the work herself.

The problem is that 2005 and 2006 were before she borrowed from Citibank. 

Easy win for the IRS.

Our case this time was Jivago v Commissioner, Docket No. 5411-21.

Spotting The Skip Tax - Part One

I was reviewing something this week we may not have discussed before. Mind you, there is a reason we haven’t: it is a high-rent problem, not easy to understand or likely to ever apply to us normals. If you work or advise in this area (as attorney, CPA, trustee or so on), however, it can wreck you if you miss it.

Let’s talk a bit about the generation skipping tax. It sometimes abbreviated “GST,” and I generally refer to it as the “skip.”

Why does this thing even exist?

It has to do with gift and estate taxes.

You know the gift tax: you are allowed to make annual gifts up to a certain amount per donee before having to report the gifts to the IRS. Even then, you are spotted an allowance for lifetime gifts. While there may be paperwork, you do not actually pay gift tax until you exhaust that lifetime allowance.

You know the estate tax: die with enough assets and you may have a death tax. Once again, there is an allowance, and no tax is due until you exceed that allowance. The 2024 lifetime exemption is $13.6 million per person, so you can be wealthy and still avoid this tax.

As I said, we are discussing high-end tax problems.

Then there is the third in this group of taxes: the generation skipping tax. It is there as a backstop. Without it, gift and estate taxes would lose a significant amount of their bite.

Why Does the Skip Exist?

Let go through an example.

When does the estate tax apply (setting aside that super-high lifetime exemption for this discussion)?

It applies when (a) someone with a certain level of assets (b) dies.

How would a planner work with this?

Here is an idea: what if one transfers assets to something that itself cannot die? Without a second death, the estate tax is not triggered again.

What cannot die, without going all Lovecraftian?

How about a corporation?

Or – more likely – a trust?

When Does The Skip Apply?

It applies when someone transfers assets to a skip person.

Let’s keep this understandable and not go through every exception or exception to the exception.

A skip person is someone two or more generations below the transferor.

          EXAMPLE:

·       A transfer to my kid would not be a skip.

·       A transfer to my grandchild would be a skip.

What Constitutes a Transfer?

There are two main types:

·       I simply transfer assets to my grandchild. Perhaps she finishes her medical degree, and I buy and deed her first house.

·       I transfer assets through a trust.

The first type is called a direct skip. Those are relatively easy to spot, trigger the skip immediately and require a tax filing.

You already know the form on which the skip is reported: the gift tax return itself (Form 709). The form has additional sections when the skip tax applies.

          EXAMPLE:

·       I give my son a hundred grand. This is over the annual dollar limit, so a gift tax return is required. My son is not a skip person, so I need not concern myself with the skip tax sections of Form 709.

·       I give my grandson a hundred grand. This is over the annual limit, so a gift tax return is required. My grandson is also a skip person, so I need to complete the skip tax sections of Form 709.

What Is the Second Type of Transfer?

Use a trust.

Here is an example:

• Create a trust in a state that has relaxed its rule against perpetuities (RAP).

a.     This rule comes from English common law, and its intent was to limit how long a person can control the ownership and transfer of property after his/her death.

• Fund the trust at the settlor’s death.

a.     If that someone is Jeff Bezos or Elon Musk, there could be some serious money involved here.

•   The settlor’s children receive distributions from the trust. When they die, the settlor’s grandchildren take their place.

• When the grandchildren die, the great grandchildren take their place, and so on.

What we described above BTW is a dynasty trust.

The key here is - before the skip tax entered the Code in the 1970s - the then-existing gift and estate tax rules would NOT pull that trust back onto anyone’s estate return for another round of taxation.

Congress was not amused.

And you can see why a skip is defined as two generations below the transferor. Congress wanted a bite into that apple every generation, if possible.

How Does Skipping Through A Trust Work?

There are two main ways: 

EXAMPLE ONE: Say the trust has a mix of skip and nonskip beneficiaries, say children (nonskip) and grandchildren (skip). The IRS chills, because the trust might yet be includable in the taxable estate of a nonskip person. Say the last nonskip person dies (leaving only skips as beneficiaries) AND nothing is includable in an estate return somewhere. Yeah, no: this will trigger the skip tax. To make things confusing, the skip refers to this as a “termination,” even though nothing has actually terminated.   

EXAMPLE TWO: The trust again has a mix of skip and nonskip beneficiaries. This just like the preceding, except we will not kill-off the nonskip beneficiary. Instead, the trust simply distributes to a skip or skips (say the grandchildren or great-grandchildren). This triggers the skip tax and is easier to identify and understand.

If Skipping Through A Trust, When Is the Tax Due?

Look at Example One above. This could be years – or decades – after the creation of the trust.  

The trustee is supposed to recognize that there has been a skip “termination” of the trust. The trustee would file the (Form 709) tax return, and the trust would pay the skip tax.

And – yes – in the real world it is a problem. What if the trustee (or attorney or CPA) misses the termination as a taxable event?

Malpractice, that’s what. An insurance company will probably be involved.

What About Example Two?

This is a backstop to the first type of transfer. In the second type there is still a nonskip beneficiary, meaning that the trust has not “terminated” for skip purposes. The trust distributes, but the distribution goes to a skip.

Say the trust distributes a 1965 Shelby Mustang GT350 R.

First, nice.

Second, the skip tax is paid by the beneficiary receiving the distribution. The trust does not pay this one.

Third, the trustee may want to warn the beneficiary that he/she owes skip tax on a car worth at least $3.5 million.

Fourth, realistically the trust is going to pay, whether upfront or as a reimbursement to the beneficiary. The tax paid is itself subject to the skip tax if it comes out of the trust.

How Much Is the Skip Tax?

Right now, it is 40 percent.

It changes with changes to the gift and estate tax rates.

That 1965 Shelby GT 350R comes with a skip tax of at least $1.4 million. It takes a lot of green to ride mean.

How Do You Plan for This Tax?

The skip is very much a function of using trusts in estate planning.

Trust taxation can be oddball on its own.

Introduce skip tax and you can go near hallucinatory.

This is a good spot for us to break.

We will return next post to continue our skip talk.

The Consistent Basis Rule

 

I was talking to two brothers last week who are in a partnership with their two sisters. The partnership in turn owns undeveloped land, which it sold last year. The topic of the call was the partnership’s basis in the land, considering that land ownership had been divided in two and the partnership sold the property after the death of the two original owners. Oh, and there was a trust in there, just to add flavor to the stew.

Let’s talk about an issue concerning the basis of property inherited from an estate.

Normally basis means the same as cost, but not always. Say for example that you purchased a cabin in western North Carolina 25 years ago. You paid $250 grand for it. You have made no significant improvements to the cabin. At this moment your basis is your cost, which is $250 grand.

Let’s add something: you die. The cabin is worth $750 grand.

The basis in the cabin resets to $750 grand. That means – if your beneficiaries sell it right away – there should be no – or minimal – gain or loss from the sale. This is a case where basis does not equal cost, and practitioners refer to it as the “mark to market,” or just “mark” rule, for inherited assets.

There are, by the way, some assets that do not mark. A key one is retirement assets, such as 401(k)s and IRAs.

A possible first mark for the siblings’ land was in the 1980s.

A possible second mark was in the aughts.

And since the property was divided in half, a given half might not gone through both marks.

There is something in estate tax called the estate tax exemption. This is a threshold, and only decedents’ estates above that threshold are subject to tax. The threshold for 2024 is $13.6 million per person and is twice that if one is married.

That amount is scheduled to come down in 2026 unless Congress changes the law. I figure that the new amount will be about $7 million. And twice that, of course, if one is married.

COMMENT: I am a tax CPA, but I am not losing sleep over personal estate taxes.

However, the exemption thresholds have not always been so high. Here are selected thresholds early in my career: 

		Estate Tax
Year		Exclusion
1986		500,000
1987- 1997		600,000
1998		625,000

I would argue that those levels were ridiculously low, as just about anyone who was savings-minded could have been exposed to the estate tax. That is – to me, at least – absurd on its face.

One of our possible marks was in the 1980s, meaning that we could be dealing with that $500,000 or $600,000 estate threshold.

So what?

Look at the following gibberish from the tax Code. It is a bit obscure, even for tax practitioners.

Prop Reg 1.1014-10(c):

               (3) After-discovered or omitted property.

(i)  Return under section 6018 filed. In the event property described in paragraph (b)(1) of this section is discovered after the estate tax return under section 6018 has been filed or otherwise is omitted from that return (after-discovered or omitted property), the final value of that property is determined under section (c)(3)(i)(A) or (B) of this section.

(A) Reporting prior to expiration of period of limitation on assessment. The final value of the after-discovered or omitted property is determined in accordance with paragraph (c)(1) or (2) of this section if the executor, prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, files with the IRS an initial or supplemental estate tax return under section 6018 reporting the property.

(B) No reporting prior to expiration of period of limitation on assessment. If the executor does not report the after-discovered or omitted property on an initial or supplemental Federal estate tax return filed prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, the final value of that unreported property is zero. See Example 3 of paragraph (e) of this section.

(ii) No return under section 6018 filed. If no return described in section 6018 has been filed, and if the inclusion in the decedent's gross estate of the after-discovered or omitted property would have generated or increased the estate's tax liability under chapter 11, the final value, for purposes of section 1014(f), of all property described in paragraph (b) of this section is zero until the final value is determined under paragraph (c)(1) or (2) of this section. Specifically, if the executor files a return pursuant to section 6018(a) or (b) that includes this property or the IRS determines a value for the property, the final value of all property described in paragraph (b) of this section includible in the gross estate then is determined under paragraph (c)(1) or (2) of this section.

This word spill is referred to as the consistent basis rule.

An easy example is leaving an asset (intentionally or not) off the estate tax return.

Now there is a binary question:

Would have including the asset in the estate have caused – or increased – the estate tax?

If No, then no harm, no foul.

If Yes, then the rule starts to hurt.

Let’s remain with an easy example: you were already above the estate exemption threshold, so every additional dollar would have been subject to estate tax.

What is your basis as a beneficiary in that inherited property?

Zero. It would be zero. There is no mark as the asset was not reported on an estate tax return otherwise required to be filed.

If you are in an estate tax situation, the consistent basis rule makes clear the importance of identifying and reporting all assets of your estate. This becomes even more important when your estate is not yet at – but is approaching – the level where a return is required.

At $13.6 million per person, that situation is not going to affect many CPAs.

When the law changes again in a couple of years, it may affect some, but again not too many, CPAs.

But what if Congress returns the estate exemption to something ridiculous – perhaps levels like we saw in the 80s and 90s?

Well, the consistent basis rule could start to bite.

What are the odds?

Well, this past week I was discussing the basis of real estate inherited in the 1980s.

What are the odds?

Income, Clearly Realized

 

What is income?

Believe it or not, there is a line of cases over decades developing the tax concept of income.

Some instances are clear-cut: if you receive wages or salary, for example, then you have income.

Some instances may not be so clear-cut.

For example, let’s say that you receive a stock dividend. The company has a good year, and you receive – as an example – 1 additional share for every 5 shares you own.  

Do you have income?

Let’s talk this out. Let’s say that the company is worth $25 million before the stock dividend and has 1 million shares outstanding. After the stock dividend it will have 1.2 million shares outstanding. What are those extra 200,000 shares worth?

This is an actual case – Eisner v Macomber - that the Supreme Court decided in 1920. Congress had changed the tax law to tax this stock dividend, and someone (Myrtle Macomber) brought suit arguing that the law was unconstitutional.

Her argument:

·      The company was worth $25 million before the dividend

·      The company was worth $25 million after the dividend

·      She may have more shares, but her shares represent the same proportional ownership of the company.

·      She did not have any more money than she had before.

She had a point.

The Bureau of Internal Revenue (that is, the IRS) came at it from a different angle:

There was income – the income generated by the company.  The company was “distributing” said income by means of a stock dividend.

The Court reasoned that one could have income from labor or from capital. The first did not apply, and it could find nothing to support the second had happened to Mrs Macomber.

The Court decided that she did not have income.

Let’s continue.

The Glenshaw Glass Company sued the Hartford-Empire Company for damages stemming from fraud and for treble damages for business injury.

The two companies settled, and Hartford was paid approximately $325 thousand in punitive damages.

Glenshaw had no intention of paying tax on that $325 grand. That money was not paid because of labor or because of capital. It was paid because of injury to its business - returning Glenshaw to where it should have been if not for the tortious behavior.

Not labor, not capital. Glenshaw was draped all over that earlier Eisner v Macomber decision.

But the IRS had a point – in fact, 325 thousand points.

Here is the Court:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income.”

The Court levered away from its earlier labor/capital impasse and clarified income to be:

·      An increase in wealth

·      Clearly realized, and

·      Over which one has (temporary or permanent) discretion or control

In time Glenshaw has come to mean that everything is taxable unless Congress says that it is not taxable. While not mathematically precise, it is precise enough for day-to-day use.

I have a question, though.

At a conceptual level, what are the limits on the “clearly realized” requirement?

I get it when someone receive a paycheck.

I also get it when someone sells a mutual fund.

But what if your IRA has gone up in value, but you haven’t taken a distribution?

Or the house in which you raised your family has appreciated in value?

Do you have an increase in wealth?

Do you have discretion or control over said increase in wealth?

Do you have “income” that Congress can tax under Glenshaw?

The Taxation of a Bitcoin

It wasn’t too long ago I was speaking with a friend who has a high-level position in the financial industry. The conversation included a reference to Bitcoins and how they might impact what he and his company do. We spent a moment on what Bitcoins are and how they are used.

I am still a bit confused. Bitcoins are a “virtual” currency. They are not issued or backed by any nation or government. They took off as a vehicle for wealthy Chinese to get money out of the mainland, and their market value over the last year has bordered on the stratospheric: from approximately $13 to over $1,000 and back down again. Understand: there is no company in which you can buy stock. To own Bitcoins, you have to own an actual “Bitcoin,” except that Bitcoins is a virtual currency. There is no crisp $20 bill in your wallet. You will have a virtual wallet, though, and your virtual currency will reside in that virtual wallet. I suppose some virtual pickpocket could steal your virtual wallet crammed with virtual currency.

You can own a gold miner stock, for example, although the decision to do that would have proved disastrous in 2013. Then there are Bitcoin “miners,” if you can believe it. Bitcoins presents near-unsolvable mathematical problems, and – if you answer them correctly – you might receive Bitcoins in return. That is how new Bitcoins are created. There a couple of caveats here, though: first, the problems are so complicated that you pretty much have to pool your computer with other people and their computers to even have a prayer of solving the problem. There is also a dark side: the computer security firm Malwarebytes discovered that there was malware that would conscript your computer and its processing power to aid others mine for Bitcoins. Second, only 21 million Bitcoins are supposedly going to be created. Call me a cynic, but look at our government’s fiscal death wish and tell me you believe that assertion.

Bitcoins are tailored made for illegal activities. The currency is virtual; there are no bank accounts or financial institutions to transfer information to the government - yet. China has banned their financial institutions from using Bitcoins, and Thailand has made it illegal altogether. Bitcoins was tied into Silk Road, which was an eBay (of sorts) for drugs and who knows what else. One apparently had to be a computer geniac to even get to it, as Silk Road resided in the dark web and required specialized access software (such as Tor) to access. Its founder was known as Dread Pirate Roberts (I admit, I like the pseudonym), and Silk Road accepted only Bitcoins as payment. The Pirate gave an interview to Forbes and was subsequently arrested by the FBI. You can draw your own conclusion on the cause and effect.

Did you know that there are merchants out there who will accept payment in Bitcoins, and in some cases only in Bitcoins? There is even a small town in Kentucky that agreed to pay its police chief in Bitcoins.

So how would Bitcoins be taxed? It depends. Let’s say you are trading the Bitcoins themselves, the same way you would trade stocks or baseball cards. You then need to know whether the IRS considers Bitcoins to be a currency or a capital asset.

There is a downside to treating Bitcoins as a currency: IRC Section 988 treats gains and losses from currency trading as ordinary gains and losses. This means that you run the tax rates, currently topping-out at 39.6% before including the effects of the PEP and Pease phase-outs and as well as the ObamaCare taxes.

What if Bitcoins are treated as a capital asset? We would then have company. Norway has decided that Bitcoins is not a currency and will charge capital gains taxes. Germany has said the same. Sweden wants to subject Bitcoins to their VAT. The advantage to being a capital asset is that the maximum U.S. capital gains tax is 20%. However, remember that capital losses are not tax-favored. Capital losses can offset capital gains without limit, but capital losses can offset only $3,000 of other income annually.

There is a capital asset subset known as commodities. Futures trades on a currency (as opposed to trading the actual currency itself) are taxed under Section 1256, which arbitrarily splits any gain into 60% long-term and 40% short-term. Now only 60% of your gain is subject to the favorable long-term capital gains tax. However, futures contracts on Bitcoins do not yet exist.

What if you are not trading Bitcoins but rather receiving them as payment for merchandise or services? This sounds like a barter transaction, and the IRS has long recognized barter transactions as taxable. What price do you use for Bitcoins? There are multiple exchanges – Mt. Gox or coinbase, for example – with different prices. One could take a sample of the prices and average, I suppose.

I also question what to do with the price swings. Say you received a Bitcoin when it was trading at $900. Under barter rules, you would have $900 in income. You spend the Bitcoin a week or month later when the Bitcoin is worth $700. You have lost $200 in value, have you not? Is there a tax consequence here?

If it were a capital asset, you would have “bought” it for $900 and “sold” it for $700. It appears you have a capital loss.

This doesn’t necessarily mean that that the loss is deductible. Your home, for example, is a capital asset. Gain from the sale of your home is taxable if it exceeds the exclusion, but loss from the sale of your home is never deductible.

If it were a currency AND the transaction was business-related, you would have a deduction, but in this case it would be a currency loss rather than a capital loss. A currency loss is an ordinary loss and would not be subject to the $3,000 annual capital loss restriction.

If it were a currency AND the transaction was NOT business-related, you are likely hosed. This would be the same as vacationing in Europe and losing money from converting into and out of Euros. The transaction is personal, and the tax Code disallows deductions for personal purposes.

What do you have if you “mined” one of those Bitcoins? When are you taxed: when you receive it or when you dispose of it?

Bitcoins are virtual currency. Do you have to include Bitcoins when you file your annual FBAR for financial accounts outside the U.S. with balances over $10,000? Where would a Bitcoin reside, exactly?

The IRS has not told us how handle the taxation of Bitcoins transactions. Until then, we are on our own.