Publication 5550 (8-2021) Catalog Number 55082U Department of the Treasury Internal Revenue Service publish.no.irs.gov
Real Estate Property
Foreclosure and
Cancellation of Debt
Audit Technique Guide
This document is not an official pronouncement of the law or the position of the Service and cannot be
used, cited, or relied upon as such. This guide is current through the revision date. Since changes may
have occurred after the revision date that would affect the accuracy of this document, no guarantees are
made concerning the technical accuracy after the revision date.
The taxpayer names and addresses shown in this publication are hypothetical.
Audit Technique Guide Revision Date: 8/10/2021
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Table of Contents
I. Overview .............................................................................................. 7
A. Background / History ..................................................................... 7
B. Exceptions ...................................................................................... 8
B.1. Gifts ......................................................................................... 8
B.2. Deductible Debt (Lost Deduction) ......................................... 8
B.3. Purchase Price Reduction ..................................................... 8
C. Relevant Terms .............................................................................. 9
D. Key Tax Issues ............................................................................. 10
II. Type of Debt - Nonrecourse and Recourse Debt ............................ 12
A. Nonrecourse Debt ........................................................................ 13
A.1. Nonrecourse Debt Examples ............................................... 14
B. Recourse Debt ............................................................................. 15
B.1. Recourse Debt Examples..................................................... 17
C. Gain and Loss Computation and Cancellation of Debt Income 17
D. Analysis of Disposition of Property Secured by Nonrecourse or
Recourse Debt ............................................................................. 18
III. Income from Discharge of Indebtedness and Items Specifically
Excluded from Gross Income ........................................................... 19
A. Bankruptcy ................................................................................... 21
A.1. Example ................................................................................. 21
A.2. Examination Consideration .................................................. 22
B. Insolvency .................................................................................... 22
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B.1. Insolvency Calculation ......................................................... 22
B.2. Examples ............................................................................... 23
B.3. Examination Consideration ................................................. 25
B.4. Audit Techniques ................................................................. 25
C. Qualified Farm Indebtedness ...................................................... 26
C.1. Examples ............................................................................... 27
C.2. Examination Consideration ................................................. 28
D. Qualified Real Property Business Indebtedness ....................... 28
D.1. Example ................................................................................. 31
D.2. Examination Consideration ................................................. 32
E. Qualified Principal Residence Indebtedness ............................. 32
E.1. Indebtedness That Does Not Qualify ................................... 33
E.2. Examples ............................................................................... 34
E.3. Other Tax Considerations .................................................... 37
E.4. Examination Consideration ................................................. 38
E.5. Audit Techniques ................................................................. 38
IV. Tax Attribute Reduction .................................................................... 38
A. Reduction of Tax Attributes ........................................................ 38
A.1. Election to Reduce Basis First ............................................ 40
A.2. Election to Treat Certain Inventory as Depreciable Property
40
A.3. Depreciation Recapture Reductions ................................... 41
A.4. Summary of Tax Attribute Reduction Rules ....................... 41
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B. Bankruptcy, Insolvency, and Farm - Attributes Reduction ....... 44
B.1. Bankruptcy Attribute Reduction Examples ........................ 45
B.2. Insolvency Attribute Reduction Examples ......................... 48
B.3. Other Considerations for Bankrupt or Insolvent Taxpayers
50
B.4. Basis Example ...................................................................... 51
B.5. Qualified Farm Indebtedness - Basis Attribute Reduction 53
C. Qualified Real Property Business Indebtedness - Attribute
Reduction ..................................................................................... 55
C.1. Recapture Reductions ......................................................... 55
C.2. Examples .............................................................................. 56
D. Qualified Principal Residence Indebtedness - Attribute
Reduction ..................................................................................... 59
D.1. Examples .............................................................................. 59
V. Rental Real Estate Property.............................................................. 61
A. Overview ....................................................................................... 61
B. Qualifying Dispositions Under IRC § 469(g) .............................. 61
C. Disqualifying Dispositions Under IRC § 469(g) ......................... 63
D. Depreciation Recapture ............................................................... 64
E. Character of Property at Disposition .......................................... 64
F. Lease with Option to Buy ............................................................ 65
G. Examples ...................................................................................... 65
H. Audit Strategies ........................................................................... 67
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VI. Abandonments .................................................................................. 68
A. Tax Consequences of Abandonments ....................................... 68
B. Examples ...................................................................................... 70
VII. Form 1099-A and Form 1099-C ......................................................... 71
A. Background .................................................................................. 71
B. Example ........................................................................................ 72
C. Examination Considerations ....................................................... 73
D. Inaccurate or Questionable Forms 1099-A and 1099-C ............. 75
D.1. Form 1099-C Box 2. Amount of Debt Discharged .............. 75
D.2. Form 1099-A Box 4 & Form 1099-C Box 7. Fair Market
Value (FMV) of Property ......................................................... 75
D.3. Form 1099-A & Form 1099-C Box 5. Check here if the
Debtor was Personally Liable for Repayment of the Debt ... 76
D.4. Form 1099-C Box 6. Identifiable Event Code ...................... 76
VIII. Community and Common Law Property .................................... 77
A. Community and Common Law Property Systems..................... 77
B. Community Property ................................................................... 78
B.1. Income ................................................................................... 79
B.2. Deductions ............................................................................ 79
B.3. Gains and Losses ................................................................. 79
B.4. Community Property Examples........................................... 79
IX. Rehabilitation Credit and IRC § 469 ................................................. 81
A. Background .................................................................................. 81
B. Audit Hints .................................................................................... 82
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X. Low Income Housing Credit & IRC § 469 ......................................... 83
A. IRC § 469 - $25,000 Offset ........................................................... 83
B. Disposition of Passive Activity ................................................... 83
XI. Audit Strategies and Case File Documentation .............................. 84
A. Summary of Real Estate Property Audit Strategies .................. 84
B. Case File Documentation ............................................................ 87
C. Standard Paragraphs and Explanation of Adjustments ............ 87
XII. Job Aids ............................................................................................. 87
A. Job Aid 1 - Insolvency Worksheet .............................................. 87
B. Job Aid 2 - Sample Information Document Request ................. 88
C. Job Aid 3 - Sample Initial Interview Questions - Principal
Residence ..................................................................................... 89
D. Resources for Real Estate Foreclosures and Cancellation of
Debt Income ................................................................................. 90
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I. Overview
(1) This audit technique guide discusses the tax consequences for real estate
property that is disposed of through foreclosure, short sale, deed in lieu of
foreclosure, and abandonments. Although, the term foreclosure is used
throughout this document, the tax treatment also applies to short sales, deed in
lieu of foreclosures, and abandonments. A discussion is also devoted to
cancellation of debt income exclusions that are most commonly applicable to
these types of dispositions and community property considerations. This guide
primarily focuses on tax consequences for individual taxpayers. Keep in mind
that the examples presented in this Audit Technique Guide are general
examples and should not solely be relied upon for every situation as each fact
pattern may change the tax consequences.
A. Background / History
(1) According to the U.S. Department of Housing and Urban Development (HUD)
and the U.S. Department of the Treasury’s December 2013 Housing Scorecard,
3.6 million cumulative completed foreclosures occurred from April 2009 through
October 2013. This number includes investment, second home, and jumbo
mortgage properties (high-end properties).
(2) Many taxpayers were unaware that even though their lender foreclosed on their
properties, there could be tax consequences and the lender could legally
pursue collection of any outstanding deficiency. In 2009, the government
stepped in to help distressed homeowners and implemented various assistance
programs, such as the Making Home Affordable Program, as a strategy to help
homeowners avoid foreclosure, stabilize the country's housing market, and
improve the nation's economy. Federal and State governments have filed
numerous lawsuits against lending institutions for unfair and/or fraudulent
practices. As a result, mortgage lenders have implemented changes.
(3) IRC § 61(a)(11), IRC § 61(a)(12) prior to January 1, 2019, provides that gross
income includes income from discharge of indebtedness. When money is
borrowed, the loan proceeds are not included in income because an obligation
to repay the lender exists. Generally, when debt for which a taxpayer is
personally liable is subsequently forgiven, the amount received as loan
proceeds is reportable as income because an obligation to repay the lender no
longer exists, which results in an economic benefit to the taxpayer.
(4) Under IRC § 108(a) taxpayers may exclude discharged debt if the taxpayer is
bankrupt, insolvent, the discharged debt is qualified farm indebtedness, the
discharged debt is qualified real property business indebtedness, or if the
discharged debt is qualified principal residence indebtedness. Form 982,
Reduction of Tax Attributes Due to Discharge of Indebtedness (And Section
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1082 Basis Adjustment), is completed to report the exclusion and the reduction
of certain tax attributes either dollar for dollar or 33 1/3 cents per dollar.
(5) PLR 8918016, 1989 WL 595222, states that, “[A]ccording to legislative history
of the Bankruptcy Tax Act of 1979, the purpose of IRC §108 is to accommodate
both tax and bankruptcy policies. Due to the Supreme Court’s decision in
United States v. Kirby Lumber Co., 284 U.S. 1 (1931), tax policy requires
debtors to include in gross income the amount of debt they are no longer
required to repay, including debts discharged in bankruptcy.”
(6) The Mortgage Forgiveness Debt Relief Act of 2007 allowed qualifying taxpayers
to exclude debt discharged as income from a borrower’s principal residence.
Consequently, IRC § 108(a)(1)(E) was added to the Internal Revenue Code.
B. Exceptions
(1) Gifts, deductible debt, and purchase price reduction are exceptions to IRC §
61(a)(11) where discharged debt is not taxable. These exceptions apply before
the exclusions under IRC § 108(a)(1) and do not require a reduction of tax
attributes.
B.1. Gifts
(1) If forgiveness of the debt is a gift, then generally, it is not considered income.
However, the donor may be required to file a gift tax return.
B.2. Deductible Debt (Lost Deduction)
(1) If the payment of the debt would result in a deduction, then the cancellation of
the debt is not included in gross income. For example, Marvin was discharged
of $50,000 ($20,000 principal and $30,000 interest) of mortgage debt. If Marvin
would have made the mortgage payments, he may have been able to deduct
the $30,000 as mortgage interest expense on his tax return. Since Marvin did
not make his mortgage payments, the $30,000 is a lost deduction. Thus,
Marvin’s cancellation of debt income is $20,000.
B.3. Purchase Price Reduction
(1) If the seller reduces the amount of debt owed for property purchased, the
reduction generally does not result in cancellation of debt income. The
reduction of the debt is treated as a purchase price adjustment and reduces the
property’s basis. In comparison, if a bank or financial institution that holds the
mortgage note reduces or modifies the balance of the loan, the debt restructure
is treated as a loan modification and is not considered a purchase price
reduction.
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(2) For example, Jane purchased a residence from Jamie and obtains a mortgage
loan from a third party, Adam. During escrow, Jamie decides to reduce the
purchase price of the property due to a problem discovered during the house
inspection. Jamie’s reduction of the purchase price is considered a purchase
price reduction and not cancellation of debt.
C. Relevant Terms
(1) Cancellation of Debt Income (CODI) – Also known as cancellation of
indebtedness income (COII) – If a lender forgives a borrower of all or part of an
outstanding debt owed, the borrower is considered to have received a benefit
that has put him/her into a better financial position.
(2) The amount of the benefit must be reported as income received under
IRC § 61(a)(11), unless the taxpayer qualifies for an income exclusion under
IRC § 108.
(3) Deed in Lieu of Foreclosure – The borrower returns the property back to the
lender in full satisfaction of the mortgaged outstanding debt balance upon an
agreement by the lender. The principal advantage to the borrower is that it
immediately releases him/her from most or all of the personal indebtedness
associated with the defaulted loan.
(4) Final Closing Statement or HUD-1 - This form is used as a statement of actual
charges and adjustments paid by the borrower and the seller. The concept is
similar to that of the T- account where all incoming and outgoing amounts of the
real estate transaction are listed. Both parties receive a copy of this statement
before or at closing. A sample of the Settlement Statement (HUD-1) can be
found on the United States Department of Housing and Urban Development
website.
(5) Foreclosure – A legal procedure by which mortgaged real estate property is
sold by the lender in full or partial satisfaction of the mortgage debt. For
example, if the borrower fails to pay the monthly mortgage payments, the lender
takes the property back and sells it to recover some or all of the debt. If
proceeds from the sale fail to pay recourse debt in full, the lender may obtain a
deficiency judgment in court to recover the outstanding balance. The
foreclosure proceeding and whether the lender is able to obtain a deficiency
judgment is determined by the law of the state where the property is located.
(6) Nonrecourse Debt – The borrower is not personally liable and repossession of
the mortgaged property, for example, will generally satisfy the outstanding debt.
(7) Recourse Debt – The borrower is personally liable for the loan. Meaning, the
lender can obtain a deficiency judgment against the borrower in court for any
outstanding balance that is not satisfied through a foreclosure sale. State law of
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where the property is located governs whether the lender is able to obtain a
deficiency judgment.
(8) Relocation Assistance - Some taxpayers qualify for relocation funds to assist
with moving expenses. These programs are offered through federal, state and
local government, and lenders. The taxpayer may receive monies for their
principal residence, rental property and investment property. These funds are
taxable and included in the gain/loss computation.
(9) Short sale - A sale of mortgaged real estate property in which the proceeds
from selling the property will fall short of the total balance owed by the borrower.
Short sale agreements do not necessarily release the borrower from their
obligation to repay any loan deficiency unless specifically agreed to between
the lender and property owner and governing state law.
D. Key Tax Issues
(1) Foreclosure issues may not be as cut and dry as Schedule C advertising
expenses and are very factual, circumstantial and specific. One fact or
circumstance could change the result of how the foreclosure is reported on the
return. Questions should be asked and documents gathered that will address
the issues of whether the foreclosure, short sale or deed in lieu of foreclosure
resulted in a recognized gain or loss and cancellation of indebtedness income,
and how these amounts should be reported on the taxpayer’s tax return. Other
issues arise when a taxpayer excludes cancellation of debt income. Chapter 11,
Audit Strategies and Case File Documentation, includes a discussion on case
file documentation, job aids, resources, and contact information. For example,
Job Aid 2 - Sample Information Document Request, is a sample information
document request (IDR) with requests for general and loan modification
information. Job Aid 3 - Sample Initial Interview Questions - Principal
Residence, contains sample interview questions for the disposition of a principal
residence.
(2) Foreclosures, short sales and deeds in lieu of foreclosure are considered
dispositions. Keep in mind that if a taxpayer is involved in a short sale he/she
will know the date the property was sold and the sales amount, because he/she
will work closely with the real estate agent and lender during the short sale
process. The final closing statement will show the amount of the loan that will
be satisfied by the sale. The total loan balance will conceptually be equal to the
amount on the final closing statement and the amount of debt forgiven. In
comparison, a taxpayer does not become aware of the identifying information
regarding a disposition through a foreclosure, until after the lender sells the
property and generally issues a Form 1099-C, Cancellation of Debt.
(3) Once a lender repossesses real estate property through a foreclosure or the
lender becomes aware that the property owner abandoned the property, the
lender should issue the taxpayer a Form 1099-A, Acquisition or Abandonment
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of Secured Property. If the lender also forgives or cancels part or all of the
outstanding debt, a Form 1099-C should be issued to the taxpayer. If the lender
forecloses on the property and forgives the debt within the same year, then the
lender is only obligated to issue a Form 1099-C for debt canceled of $600 or
more. The taxpayer should contact the bank if the information is incorrect so
that corrected forms are issued.
(4) Confusion arises when a taxpayer receives a Form 1099-A in one year and a
Form 1099-C in a subsequent year for a recourse note. A foreclosure is a
disposition within the meaning of IRC § 1001 (Helvering v. Hammel, 311 U.S.
504 (1941)). The foreclosure sale ends the mortgagor’s ownership in the
property, and at that time, the gain or loss from the sale or other disposition of
the mortgaged property should be determined (Helvering v. Hammel, 311 U.S.
504 (1941)). Refer to the discussion in Chapter 2, Type of Debt - Nonrecourse
and Recourse Debt, for additional information.
(5) The Service has observed that lenders may issue Forms 1099 only for the
primary loan. All property loans should be considered in the determination of
any cancellation of debt income as well as gains or losses. Therefore, it is
important to ask the taxpayer questions about the events leading up to and after
the disposition. To identify all loans associated with the disposed property,
search property records and IRPTR, or review prior years’ returns for mortgage
interest. Sometimes a lender may erroneously fail to issue the taxpayer a Form
1099-C. Facts and circumstances will dictate when or if any outstanding debt
has been discharged, absent the issuance of a Form 1099-C. Under IRC §
7491(a)(1), under certain circumstances, in any court proceeding, the burden
shifts to the IRS to prove that the taxpayer received cancellation of
indebtedness income if the taxpayer provides creditable evidence with respect
to any factual issue relevant to ascertaining the income tax liability of the
taxpayer. Refer to the discussion in Chapter 7, Form 1099-A and Form 1099-C,
for additional information.
(6) Consideration of whether the lender has pursued collection activity and the
state where the property is located are two primary factors. Each state has its
own foreclosure legal laws and time frames that a lender must pursue collection
activities. Absent a Form 1099-C, it is reasonable to conclude that the taxpayer
was forgiven the outstanding balance if the lender has not pursued collection
activity in accordance with the state law of the location of the property. For
example, if a foreclosure is completed by non-judicial means in some states,
the lender is precluded from pursuing a deficiency judgment for the outstanding
balance.
(7) Some states, listed below, have anti-deficiency laws which prohibit a lender
from pursuing a deficiency judgment against the borrower under certain
circumstances. Although, these states are identified as Anti-Deficiency states, it
is important to note that each of these states has its own rules and the anti-
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deficiency rules are not applied in the same manner. It is important to
understand the state law where the property is located as it could make a
difference in the amount of income includable in taxable income or excludable
from taxable income. Anti-deficiency/nonrecourse states are identified below:
• Alaska
• Arizona
• California
• Connecticut
• Idaho
• Minnesota
• North Carolina
• North Dakota
• Texas
• Utah
• Washington
(8) It is advised to seek assistance from local Counsel for specific state questions
regarding foreclosures. Refer to the Local Law Section in IRM 5.17, Legal
Reference Guide for Revenue Officers, for more information.
(9) In general, if indebtedness is canceled or forgiven, the amount canceled or
forgiven must be included in gross income. If CODI is excluded from income, it
generally will postpone the income tax liability on cancellation of indebtedness
through the reduction of tax attributes.
II. Type of Debt - Nonrecourse and Recourse Debt
(1) As defined earlier, a loan is nonrecourse if the taxpayer is not personally liable
and the bank cannot pursue the taxpayer for any outstanding balance after the
property is foreclosed. The loan is recourse if the taxpayer was personally liable
for repayment of the loan and the bank has the right to pursue collection of all
or part of the outstanding balance after the foreclosure. The lender may have
indicated on Form 1099 whether the taxpayer was personally liable or not.
(2) Consultation with local Counsel regarding state law may assist in identification
of the type of loan. Each loan type has different tax consequences. Although, a
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taxpayer no longer owns their foreclosed property, a reportable gain or taxable
CODI from the disposition could result because foreclosures, short sales, and
deeds in lieu of foreclosure are treated as taxable dispositions.
(3) The computation of gain or loss from the sale or other disposition of property is
located in IRC § 1001. The gain is the excess of the amount realized over the
adjusted basis. The loss is the excess of the adjusted basis over the amount
realized.
A. Nonrecourse Debt
(1) A loan is nonrecourse if the taxpayer is not personally liable and the bank
cannot pursue the taxpayer for any outstanding balance after the property is
foreclosed. The borrower is not personally liable and repossession of the
mortgaged property, for example, will generally satisfy the outstanding debt.
Generally, there is no CODI from foreclosure of property with nonrecourse debt.
However, situations may exist where a taxpayer will have CODI from
nonrecourse debt. Refer to Example 5, which is an example of CODI from
nonrecourse debt.
(2) Nonrecourse debt generally has one tax consequence to consider and that is
whether a recognized gain or loss from the disposition exists. The gain/loss
calculation is the amount realized less the adjusted basis. For nonrecourse
debt, the amount realized is the greater of the outstanding debt of all loans
immediately before the foreclosure or fair market value of the property plus the
proceeds received from the foreclosure (e.g., relocation payment from the
lender). The adjusted basis immediately before the foreclosure is subtracted
from the amount realized to determine the gain or loss.
(3) IRC § 7701(g) states that the sales price is the greater of the FMV or the
outstanding loan balance for nonrecourse loans to determine the gain or loss.
(4) In Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that
when a taxpayer “sells or disposes of property encumbered by a nonrecourse
obligation exceeding the fair market value of the property sold, as in this case,
the Commissioner may require him to include in the “amount realized” the
outstanding amount of the obligation; the fair market value of the property is
irrelevant to this calculation.” The Court reasoned that because a nonrecourse
note is treated as a true debt upon inception (so that the loan proceeds are not
taken into income at that time), a taxpayer is bound to treat the nonrecourse
note as a true debt when the taxpayer is discharged from the liability upon
disposition of the collateral, in spite of the lesser fair market value of the
collateral.
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A.1. Nonrecourse Debt Examples
(1) Example 1. Maxine paid $200,000 for her second home. She put $15,000 down
and borrowed the remaining $185,000 from a bank. Maxine is not personally
liable for the loan, but pledges the house as security. The bank foreclosed on
the mortgage because Maxine stopped making payments. When the bank
foreclosed on the loan, the balance due was $180,000, the fair market value of
the house was $170,000, and Maxine’s adjusted basis was $175,000 due to a
casualty loss she had deducted. Maxine has a gain of $5,000 ($180,000
outstanding debt minus $175,000 adjusted basis) from the foreclosure.
(2) The lender’s foreclosure on property secured by nonrecourse debt that is
greater than the FMV of the property does not result in cancellation of debt
income. The entire amount of the nonrecourse debt is treated as the amount
realized. As such, Maxine recognized no CODI upon the foreclosure, but
realized $180,000, the outstanding debt balance immediately before the
foreclosure. Her gain is the difference between the loan balance of $180,000
and the adjusted basis of $175,000. Maxine has a $5,000 recognized gain from
the foreclosure of her second home. The disposition is reported on Form 8949,
Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains
and Losses.
(3) Generally, there is no cancellation of debt income from foreclosure of property
when nonrecourse debt secures the property, because repossession of the
mortgaged property will satisfy the outstanding debt. The lender’s foreclosure
on property secured by nonrecourse debt that is greater than the FMV of the
property does not result in cancellation of debt income. The entire amount of
the nonrecourse debt is treated as the amount realized.
(4) However, in certain situations, the discharge of nonrecourse debt will result in
CODI. Revenue Ruling 91-31, 1991-1 C.B. 19 provides that the reduction of the
principal amount of an undersecured nonrecourse debt (nonrecourse debt
greater than the fair market value of the property) results in CODI. For example,
a reduction in the loan balance through a loan modification will result in CODI
when nonrecourse debt exceeds fair market value of the property.
(5) Confusion exists as to the year that the disposition should be reported when the
lender repossesses property and then sells it in a subsequent year. If the note
that secured the property was nonrecourse, the disposition is reported in the
year of repossession.
(6) Example 2. Walter paid $580,250 for his second home. He paid $30,000 down
and borrowed the remaining $550,250 from a bank. Walter is not personally
liable for the loan, but pledges the house as security. When the fair market
value of the property dropped to $400,000 and the loan balance was $535,698,
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the bank agreed to modify his loan and reduced the principal balance by
$52,435.
(7) Walter did not qualify to exclude the cancellation of debt income from gross
income under IRC § 108. Therefore, Walter would report $52,435 as other
income on Form 1040 for the discharged nonrecourse debt.
B. Recourse Debt
(1) The loan is recourse if the taxpayer was personally liable for repayment of the
loan and the bank has the right to pursue collection of all or part of the
outstanding balance after the foreclosure. Recourse debt has three different
potential tax consequences which are (1) CODI, (2) gain/loss from the
disposition, and (3) the reduction of tax attributes if CODI is excluded from
income.
(2) The first calculation is to determine the amount of cancellation of debt income.
Cancellation of debt income is determined by the outstanding debt balance
immediately before the foreclosure (minus debt liable after the foreclosure)
minus the fair market value of the property equals the cancellation of debt
income.
(3) Cancellation of debt income may be excluded if the taxpayer qualifies under
IRC § 108. Form 982 is used to report the exclusion and any reduction of
certain tax attributes.
(4) Taxable cancellation of debt income is reported as:
• Non-business Debt – Form 1040 as other income.
• Sole Proprietorship – Schedule C or F as other income, if the debt is
related to a sole proprietorship nonfarm or farm business.
• Non-Farm Rental Activity – Schedule E as other rental income, if the debt
is related toa nonfarm rental of real property.
• Farm Rental Activity – Form 4835 to report rental income based on crops
or livestock produced by a tenant.
(5) In general, if taxable income (including CODI) is derived from a trade or
business and is reported on a Schedule C or F, then it is self-employment
income and it will be subject to self-employment tax. If an exception applies to
exclude CODI from gross income, the CODI is also not self-employment income
subject to self-employment tax. Self-employment income means the “net
earnings from self-employment derived by an individual” IRC § 1402(b). Net
earnings from self-employment is defined as “the gross income derived by an
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individual from any trade or business carried on by such individual, less the
deductions allowed by this subtitle which are attributable to such trade or
business, plus his distributive share (whether or not distributed) of income or
loss described in IRC § 702(a)(8) from any trade or business carried on by a
partnership of which he is a member” IRC § 1402(a) and Treas. Reg. §
1.1402(a)-1.
(6) The second tax consequence for a recourse note is the calculation of the gain
or loss from the foreclosure sale. The gain or loss is calculated as the amount
realized plus any proceeds received from the foreclosure (e.g., relocation
payment from the lender) minus the adjusted basis of the property immediately
before the foreclosure sale. The amount realized is the lesser of the fair market
value of the property or outstanding debt balance.
(7) The fair market value of a property may be in question during an examination.
That is because the sales price of the property is generally determined to be the
fair market value of the property. This amount may be different from the amount
reported on Form 1099-A. In Frazier v. Commissioner 111 T.C. 243, 246 (1998)
the court stated, “Absent clear and convincing proof to the contrary, the sale
price of property at a foreclosure sale is presumed to be its fair market value.”
See Community Bank v. Commissioner, 79 T.C. 789, 792 (1982), affd. 819 F.2d
940 (9th Cir.1987).
(8) The third potential tax consequence of a recourse note is the reduction of tax
attributes when cancellation of debt income is excluded from gross income.
Generally, tax attributes are reduced by the amount of CODI excluded from
income. Reduction of tax attributes is discussed later under Reduction of Tax
Attributes in Chapter 4.
(9) Confusion exists as to the year that the disposition should be reported when the
lender repossesses property and then sells it in a subsequent year. If the note
that secured the property was recourse, the disposition is reported in the year of
the foreclosure sale.
(10) Property which secures a taxpayer's recourse obligation is not worthless prior to
foreclosure. Commissioner v. Green, 126 F. 2d 70, 72 (3d Cir. 1942) (“where,
as here, the taxpayer is liable for the debt, interest and taxes by virtue of the
mortgage or the bond thereby secured, the property continues, until foreclosure
sale, to have some value which, when determined by the sale, bears directly
upon the extent of the owner's liability for a deficiency judgment.”). Likewise,
property which secures a taxpayer's recourse obligation may not be considered
abandoned for purposes of a loss deduction prior to foreclosure. Daily v.
Commissioner, 81 T.C. 161 (1983) (an attempt to abandon property subject to
recourse debt does not result in a deductible loss), aff'd, Daily v Commissioner,
742 F.2d 1461 (9th Cir. 1984). Once the year of disposition is identified and the
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type of debt is identified that secured the real estate property, the computation
of the gain or loss and any CODI can be made.
B.1. Recourse Debt Examples
(1) Example 3. Marcus bought his second home for $400,000 in year 1. He paid
$30,000 down and borrowed the remaining $370,000 from a bank. Marcus is
personally liable for the loan and the house is pledged as security for the loan.
Marcus lost his job several years later and the bank declined his requests for a
loan modification. Although, Marcus found another job, he earned less and was
unable to make the mortgage payments and the bank ultimately foreclosed on
the home in year 12. Marcus moved out of the home in year 12.
(2) The recourse debt balance before the foreclosure was $350,000. In the same
year, the bank sold the property for $250,000 to a third party. After the
foreclosure sale, the bank forgave $60,000 of the $100,000 debt in excess of
the FMV ($350,000 minus $250,000) and Marcus remained liable for the
$40,000 balance. He did not qualify for any of the exclusions in IRC § 108(a)(1).
(3) In year 12, Marcus has cancellation of debt income of $60,000 ($350,000 debt
balance immediately before the foreclosure minus $40,000 amount personally
liable immediately after the foreclosure sale minus $250,000 FMV of the
property). Under the circumstances, Marcus has other income of $60,000 from
the canceled debt. His nondeductible loss is $150,000 ($250,000 FMV of the
property minus $400,000 adjusted basis of the property).
(4) Marcus would file Form 982 to report the CODI exclusion and complete Part I
for discharge of qualified principal residence indebtedness. Marcus should also
report the foreclosure on Form 8949, Sales and Other Dispositions of Capital
Assets as a nondeductible loss. For more details, see Nondeductible Losses in
the instructions to Schedule D, Capital Gains and Losses.
(5) Example 4. Jimmy took out a recourse loan for $700,000 to purchase an office
building to expand his sole proprietorship realty business. Three years later,
through a loan modification, the bank forgave $78,000 of the loan balance when
the FMV of the property was $600,000. Jimmy would report $78,000 on
Schedule C as other income if he did not qualify to exclude some or the entire
amount of CODI under IRC § 108.
C. Gain and Loss Computation and Cancellation of Debt Income
(1) The computation of gain or loss from the sale or other disposition of property is
located in IRC § 1001. The gain is the excess of the amount realized over the
adjusted basis. The loss is the excess of the adjusted basis over the amount
realized.
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(2) The amount realized is defined in IRC § 1001(b) as money received plus the
fair market value of the property received (other than money). As discussed
later, the amount realized for nonrecourse notes is the greater of the fair market
value (FMV) of the property or the outstanding loan amount. The amount
realized for recourse notes is the lesser of the fair market value of the property
or the outstanding loan amount. Treas. Reg. § 1.1001-2 discusses the gain or
loss when there is a discharge of liabilities. Examples of dispositions for
nonrecourse and recourse notes are under Treas. Reg. § 1.1001-2(c).
(3) Confusion exists as to the year that the disposition should be reported when the
lender repossesses property and then sells it in a subsequent year. If the note
that secured the property was nonrecourse, the disposition is reported in the
year of repossession. If the note that secured the property was recourse, the
disposition is reported in the year of the foreclosure sale.
(4) Taxable consequences of nonrecourse and recourse debt are explained below.
The first step is to identify whether the debt is nonrecourse or recourse debt.
• Nonrecourse - If the debt is nonrecourse, there is generally one tax
consequence to consider and that is whether a recognized gain or loss
from the disposition exists.
• Recourse - If the debt is recourse, recourse debt has three different
potential tax consequences which are (1) Cancellation of debt income, (2)
gain/loss from the disposition, and (3) the reduction of tax attributes if
CODI is excluded from income.
D. Analysis of Disposition of Property Secured by Nonrecourse or
Recourse Debt
(1) The primary difference between nonrecourse and recourse debt is the timing
and amount of any potential taxable income from the disposition and
cancellation of debt income demonstrated in the following Table 1, Analysis of
Disposition of Property. For this analysis, the outstanding loan balance is
$300,000, the fair market value of the property is $265,000, and the adjusted
basis is $280,000. The cancellation of debt income is $35,000 ($300,000
outstanding loan balance minus $265,000).
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(2) Table 1. Analysis of Disposition of Property
Description
Nonrecourse
Recourse
Amount realized
$300,000
$265,000
Minus adjusted basis
280,000
280,000
Equals gain/(loss)
$20,000
(15,000)
Add cancellation of debt income
35,000
Equals net gain on disposition
$20,000
(3) The nonrecourse note results in a gain of $20,000 ($300,000 amount realized
minus $280,000 adjusted basis). Whereas, the recourse note results in a
disposition loss of $15,000 ($265,000 amount realized minus $280,000
adjusted basis) plus $35,000 of cancellation of debt income resulting in a net
gain of $20,000. The overall tax consequence for both notes is a gain of
$20,000. However, the $35,000 cancellation of debt income can be deferred
through the reduction of tax attributes if the taxpayer qualifies to exclude the
cancellation of debt income under IRC § 108.
III. Income from Discharge of Indebtedness and Items Specifically
Excluded from Gross Income
(1) IRC § 61(a)(11) provides that gross income includes income from discharge of
indebtedness. When money is borrowed, the loan proceeds are not included in
income because an obligation to repay the lender exists. Generally, when debt
for which a taxpayer is personally liable is subsequently forgiven, the amount
received as loan proceeds is reportable as income because an obligation to
repay the lender no longer exists, which results in an economic benefit to the
taxpayer.
(2) As stated earlier, a foreclosure is a taxable disposition which may result in
recognized CODI and recognized gain. However, CODI can be excluded if the
taxpayer qualifies under IRC § 108. Keep in mind that the exclusions under IRC
§ 108 do not apply to the amount of gain recognized from a foreclosure, short
sale, or deed in lieu of foreclosure. Recognized gain and CODI are two
separate calculations. A taxpayer may exclude CODI under IRC § 108(a)(1) if:
• A. The discharge occurs in a bankruptcy case,
• B. The discharge occurs when the taxpayer is insolvent,
• C. The discharged indebtedness is qualified farm indebtedness,
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• D. The discharged indebtedness is qualified real property business
indebtedness (valid election), or
• E. The discharged indebtedness is qualified principal residence
indebtedness.
(3) IRC § 108(a)(2) prescribes the coordination of the exclusions and is
summarized in Table 2, Order and Coordination of Exclusions. Bankruptcy
takes precedence over all other exclusions. An insolvent taxpayer would first
look to whether his/her situation qualified under the bankruptcy exclusion. If
he/she did not qualify then, the insolvency exclusion would be considered. A
farmer would first look to whether his/her situation qualified under the
bankruptcy exclusion, then insolvency, then the farm exclusion. A taxpayer who
qualified under the real property business exclusion, would first look to whether
his/her situation qualified under the bankruptcy exclusion, then insolvency, then
the real property business exclusion. A taxpayer who qualified under the
principal residence exclusion, would first look to whether his/her situation
qualified under the bankruptcy exclusion, then the principal residence exclusion.
A taxpayer may make an election to apply the insolvency exclusion instead of
the principal residence exclusion.
(4) Table 2. Order and Coordination of Exclusions
IRC 108 Exclusions
1
2
3
Bankruptcy
Bankruptcy
Insolvency
Bankruptcy
Insolvency
Qualified Farm
Indebtedness
Bankruptcy Insolvency Farm
Qualified Real
Property Business
Bankruptcy Insolvency Business
Qualified Principal
Residence
Bankruptcy Principal
Residence (or
election to apply
insolvency
instead)
Insolvency
(5) If canceled debt is excluded from income under one or more of these
provisions, generally, tax attributes are reduced by the amount excluded (but
not below zero). This is discussed later under Reduction of Tax Attributes in
Chapter 4. These exclusions do not apply to any gain realized from foreclosure
or short sale or deed in lieu of foreclosure.
21
(6) A discussion of the exclusions follow. Please note that this guide will not cover
qualified farm indebtedness in detail. Refer to Publication 4681, Canceled
Debts, Foreclosures, Repossessions and Abandonments (for Individuals), and
Publication 225, Farmer’s Tax Guide, for more information.
A. Bankruptcy
(1) The general underlying principle of bankruptcy is to provide a debtor an avenue
to pay what the debtor can afford while receiving forgiveness for debt that
cannot be satisfied. For example, in a Chapter 7, Bankruptcy, a trustee takes
control of the debtor’s bankruptcy estate assets, liquidates nonexempt property,
and distributes the cash to creditors. Remaining unpaid debts are generally
discharged. After the trustee winds down the affairs, if any property remains,
the trustee will transfer the property back to the debtor. Refer to IRM 5.9,
Bankruptcy and Other Insolvencies, for additional information. IRM Exhibit
5.9.1-1 includes a glossary of common insolvency terms. Examiner
responsibilities are discussed in IRM 4.27.1, Bankruptcy, Examiner
Responsibilities and Procedures.
(2) IRC § 108(a)(1)(A) allows for cancellation of debt income to be excluded from
income where the debt was discharged in a bankruptcy case. However, merely
filing for bankruptcy does not meet this exclusion – the debt must have been
discharged during the course of the bankruptcy case. As discussed earlier, the
bankruptcy exclusion takes precedence over the other exclusions in IRC §
108(a)(1).
(3) Once you discover that a taxpayer has filed for bankruptcy, it is important that
you contact the bankruptcy coordinator in Technical Services who would be
able to provide information about the bankruptcy. It is important to know the
status of the bankruptcy, because it could affect how you proceed with the
case. If applicable, communicate with the Collection Officer assigned to the
case in a timely manner so that Collection is able to take appropriate action
within required timeframes.
A.1. Example
(1) Example 5 (Part I of Example 18, Chapter 4). Tara owed several creditors
and was no longer able to meet her financial obligations, as a result, she filed
for Chapter 7 bankruptcy and was granted a discharge of her recourse debt of
$174,678 in year 1. Tara excluded the $174,678 from taxable income on her
Form 1040 (year 1) tax return and attached Form 982 to report the exclusion
and amount. She checked line 1a to report that the discharge was in a title 11
case (bankruptcy) and entered $174,678 on line 2 of Form 982. Tara is also
required to reduce tax attributes. Refer to Example 18 for the attribute reduction
calculation.
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A.2. Examination Consideration
(1) The bankruptcy exclusion is NOT an election. Although, Form 982 is used to
report the exclusion type, amount of CODI excluded from gross income, and the
tax attribute reduction, it is not required to be filed with a tax return for the
bankruptcy exclusion. Failure to attach a Form 982 to a tax return does not
prevent a taxpayer from excluding cancellation of debt income under the
bankruptcy exclusion. As such, a taxpayer can present documentary evidence
for consideration during an examination. An examiner should gather all
necessary documents and develop relevant facts to determine whether a
taxpayer meets the bankruptcy exclusion.
B. Insolvency
(1) IRC § 108(a)(1)(B) provides that gross income does not include cancellation of
debt income if the discharge occurs when the taxpayer is insolvent. This
exclusion takes precedence over the qualified farm and qualified real property
business exclusions.
(2) IRC § 108(d)(3) defines insolvent as the excess of liabilities over the fair market
value of assets, immediately before the discharge. A taxpayer can exclude
cancellation of debt income up to the amount of insolvency per IRC § 108(a)(3).
The CODI amount excluded cannot exceed the amount by which a taxpayer is
insolvent. A spouse does not realize CODI from their spouse’s discharge of
debt.
B.1. Insolvency Calculation
(1) Both tangible and intangible assets are included in the calculations. Assets also
include exempt assets as defined by state law. The separate assets of a
debtor's spouse are not included in determining the extent of insolvency of the
debtor. For more information, refer to Chapter 8, Community and Common Law
Property, discussed later.
(2) Both recourse and nonrecourse liabilities are included in the insolvency
computation, while contingent liabilities are not included. Accrued but unpaid
interest expenses and income taxes that have become an obligation of the
debtor, along with other fixed and certain claims are considered liabilities of the
debtor. The separate liabilities of a debtor's spouse are not included in the
calculation of the debtor. Refer to Chapter 8, Community and Common Law
Property Systems discussed later for more information.
(3) In Shepherd et ux. v. Commissioner, T.C. Memo. 2012-212, the court decided
that the taxpayers did not meet their burden to prove the fair market value of
two properties at the time of discharged debt and the taxpayers failed to include
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at least a percentage (amount he was able to withdraw), of the husband’s
retirement account, as an asset in their insolvency calculation.
(4) Job Aid 1 - Insolvency Worksheet, included in Chapter 11, Audit Strategies and
Case File Documentation, can be used to determine the extent of insolvency.
The worksheet is also located in Publication 4681.
B.2. Examples
(1) Example 6 (Part I of Example 20, Chapter 4). Ashley was unable to pay her
recourse mortgage for her second home after her divorce. She entered into a
deed in lieu of foreclosure agreement with the lender on October 1 of year 1
and simultaneously forgiven of the outstanding debt. The bank subsequently
issued a Form 1099-C for $50,000 discharged debt.
(2) Ashley's total liabilities immediately before the cancellation were $756,589 and
the FMV of her total assets immediately before the cancellation were $726,329.
In this case, Ashley is insolvent to the extent of $30,260 ($756,589 total
liabilities minus $726,329 FMV of her total assets) immediately before the
cancellation. Ashley can exclude only $30,260 of the $50,000 canceled debt
from income under the insolvency exclusion. IRC § 108(a)(3). Ashley would
report $19,740 ($50,000 debt forgiven minus $30,260 extent of insolvency) of
the CODI as other income on her Form 1040. She would also attach Form 982
to her tax return, and check line 1b and enter $30,260 on line 2. Ashley would
also complete Form 982 Part II to reduce her tax attributes as illustrated in
Example 20.
(3) What happens if a taxpayer is partially discharged of a nonrecourse debt when
applying IRC §108(d)(3), insolvency exclusion? Revenue Ruling 92-53, 1992-2
C.B. 48 addresses the treatment of nonrecourse indebtedness when applying
the insolvency exclusion. The ruling states that, “…the amount by which a
nonrecourse debt exceeds the fair market value of the property securing the
debt is taken into account in determining whether, and to what extent, a
taxpayer is insolvent within the meaning of section 108(d)(3) of the Code, but
only to the extent that the excess nonrecourse debt is discharged.” Excess
nonrecourse debt is the amount of nonrecourse debt that exceeds the fair
market value of the property that the debt secures. Example 7 and Example 8
demonstrate the application of this Revenue Ruling.
(4) Example 7. Samantha entered into a loan modification and the lender agreed
to reduce the principal balance of the nonrecourse loan from $195,000 to
$175,000 when the value of the home declined. At the time of the loan
modification, the fair market value of the home was $150,000. Samantha’s
other liabilities consisted of recourse debt of $80,000 and nonrecourse debt
(limited to the FMV of the assets that secures the debt) of $30,000 and the FMV
24
of other assets was $70,000. Three years later the lender foreclosed on the
property due to Samantha’s failure to pay her monthly mortgage payments.
(5) In this situation, $20,000 ($195,000 original mortgage minus $175,000 new
mortgage) of Samantha’s $45,000 ($195,000 original mortgage minus $150,000
FMV of the property) excess nonrecourse debt is discharged. Only the portion
of the excess nonrecourse debt that is discharged is taken into account in
determining to what extent Samantha is insolvent.
(6) Samantha’s total liabilities are $280,000 ($150,000 nonrecourse debt limited to
FMV of the home plus $20,000 excess nonrecourse debt limited to discharged
amount plus $110,000 other recourse and nonrecourse liabilities). Nonrecourse
debt ($175,000) is limited to the fair market value ($150,000) of the asset that
secures the loan, because the taxpayer is not personally liable and generally
not expected to pay any outstanding balance if the property is repossessed.
Samantha’s total assets right before the discharge are $220,000 ($150,000
FMV of the home plus $70,000 FMV of other assets).
(7) Samantha is insolvent by $60,000 ($280,000 total liabilities minus $220,000
total assets). Since the discharged amount of $20,000 is less than the extent
that Samantha is insolvent, the entire $20,000 can be excluded from income
under IRC §108(a)(1)(B).
(8) Example 8. Naomi entered into a loan modification and the lender agreed to
reduce the principal balance of the recourse loan from $195,000 to $175,000
when the value of the home declined. At the time of the loan modification, the
fair market value of the home was $150,000. Naomi’s other liabilities consisted
of recourse debt of $80,000 and nonrecourse debt (limited to the FMV of the
assets that secures the debt) of $30,000 and the FMV of other assets was
$70,000. Four years later, Naomi was unable to make her mortgage payments
and disposed of the property through a short sale.
(9) The amount discharged by the lender was $20,000 ($195,000 original mortgage
minus $175,000 new mortgage amount).
(10) Total liabilities right before the discharge was $305,000 ($195,000 recourse
debt plus $110,000 other recourse and nonrecourse liabilities). Nonrecourse
debt is limited to the fair market value of the asset that secures the loan,
because the taxpayer is not personally liable and not expected to pay any
outstanding balance if the property is repossessed.
(11) Total assets right before the discharge was $220,000 ($150,000 FMV of the
home plus $70,000 FMV of other assets).
(12) Naomi is insolvent by $85,000 ($305,000 total liabilities minus $220,000 total
assets). Since the discharged amount of $20,000 is less than the extent that
25
Naomi is insolvent, the entire $20,000 can be excluded from income under IRC
§ 108(a)(1)(B).
(13) In both examples (7 and 8), the taxpayers are able to exclude the entire
discharged debt. However, the treatment of the nonrecourse loans changed the
amount that the taxpayer is insolvent. In Example 7, a portion of Samantha’s
nonrecourse loan was discharged which resulted in an insolvency amount of
$60,000, due to the limitations applied to the nonrecourse loans. In contrast, in
Example 8, Naomi had discharged recourse debt which resulted in an
insolvency amount of $85,000, even though the mortgage loan amounts were
identical.
B.3. Examination Consideration
(1) Similar to the bankruptcy exclusion, the insolvency exclusion is NOT an
election. Although, Form 982 is used to report the exclusion type, amount of
CODI excluded from gross income, and the tax attribute reduction, it is not
required to be filed with a tax return for the insolvency exclusion. Failure to
attach a Form 982 to a tax return does not prevent a taxpayer from excluding
cancellation of debt income under the insolvency exclusion. Failure to attach a
Form 982 to a tax return does not prevent a taxpayer from excluding
cancellation of debt income from gross income. As such, a taxpayer can
present documentary evidence for consideration during an examination. An
examiner should gather all necessary documents and develop relevant facts to
determine whether a taxpayer meets the insolvency exclusion.
B.4. Audit Techniques
(1) Review the taxpayer’s insolvency calculation for reasonableness and request
supporting documentation as warranted.
(2) Look for any liabilities that might be associated with a corresponding asset. For
example, if a car loan is listed, the fair market value of the vehicle should be
listed under assets, unless the vehicle was repossessed.
(3) Generally, mortgage lenders will conduct an appraisal of the property during a
short sale process. Thus, a comparison of the fair market value on the Forms
1099-A and/or 1099-C with the taxpayer’s insolvency calculation can be done to
identify any differences. If you do identify any differences, request that the
taxpayer explain how they determined the fair market value for the property
especially, if the difference puts the taxpayer in an insolvent position.
(4) Taxpayers with high monthly income may in fact be insolvent. The insolvency
calculation considers the taxpayers overall financial position right before the
discharge of debt.
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C. Qualified Farm Indebtedness
(1) Under IRC § 108(a)(1)(C) discharged qualified farm indebtedness after April 9,
1986, may be excluded from gross income. Generally, the exclusion for
qualified farm indebtedness allows a taxpayer who is in the business of farming
to reduce tax attributes in lieu of recognizing discharge of indebtedness income.
However, the taxpayer must first apply the rules for bankruptcy and then
insolvency under IRC § 108(a)(1)(A) and IRC § 108(a)(1)(B), respectively.
Taxpayers who have additional CODI after applying the insolvency exclusion
can use this exclusion for qualified farm debt.
(2) Under IRC § 108(g)(1), a discharge of debt qualifies for the qualified farm
indebtedness exclusion only if the discharge is by a creditor who is a qualified
person. A qualified person is defined in IRC § 108(g)(1)(B) as any federal, state
or local government or agency or instrumentality thereof and includes IRC §
49(a)(1)(D)(iv) an individual, organization, partnership, association, corporation,
etc. who regularly engaged in the business of lending money, which is not a
related person (as defined in IRC § 465(b)(3)(C)) with respect to the taxpayer.
(3) Two requirements must be met under IRC § 108(g)(2), for indebtedness to
qualify as qualified farm indebtedness. First, the indebtedness must have been
incurred directly in connection with the business of farming. Secondly, fifty
percent or more of the taxpayer's aggregate gross receipts for the three taxable
years preceding the taxable year of the discharge, must have been attributable
to the trade or business of farming.
(4) In addition, IRC § 108(g)(3) states that the excluded income cannot exceed the
sum of the adjusted tax attributes of the taxpayer plus the aggregate adjusted
bases of qualified property held by the taxpayer as of the beginning of the
taxable year following the taxable year of the discharge. Under IRC §
108(g)(3)(B), the adjusted tax attributes of the taxpayer are the sum of tax
attributes other than bases under IRC § 108(b)(2).
(5) The adjusted tax attributes are determined as the net operating loss (NOL) for
the year of discharge and any NOL carryover to the year of discharge plus any
net capital loss for the year of discharge and any capital loss carryover to the
year of discharge plus any passive activity loss carryover from the year of
discharge. Add three times the sum of any general business credit carryover to
or from the year of discharge and minimum tax credit available as of the
beginning of the following year of discharge and foreign tax credit carryover to
or from the year of discharge, and any passive activity credit carryover from the
year of discharge.
(6) IRC § 108(g)(3)(C), defines qualified property as any property used or held in a
trade or business or for the production of income. A taxpayer may elect on
Form 982 to treat real property held primarily for sale to customers as if it were
depreciable property. To the extent, the amount of the discharge exceeds the
27
sum of the relevant amounts, the taxpayer is required to recognize cancellation
of indebtedness income.
(7) More information about farming and agriculture issues can be found in
Publication 225, Farmer's Tax Guide.
C.1. Examples
(1) Example 9. Karla has been in the business of farming for the past five years
and is neither bankrupt nor insolvent. As of February 1, of year 1, she had total
debt of $140,000, total adjusted tax attributes of $80,000, and total adjusted
bases in qualified property as of January 1, of year 2, of $60,000. No other
exception or exclusion applied. Karla’s qualified creditors discharged the
$140,000 of debt in year 1 and subsequently issued a Form 1099-C. Karla can
exclude all $140,000 ($80,000 plus $60,000) of the canceled debt from income.
(2) Rev. Rul. 76-500, 1976-2 C.B. 254 states that “…the amount of the canceled
portion of a loan represents a replacement of a portion of a farmer's lost profits
and must be taken into account in computing net earnings from self-
employment for purposes of the tax on self-employment income”. Rev. Rul. 73-
408, 1973-2 C.B. 15, held that the canceled portion of an emergency loan
granted to a farmer by the Farmers Home Administration was includible in the
farmer's gross income. As such, taxable CODI is reported as other farming
income and is subject to self-employment tax.
(3) Example 10 (Part I of Example 23, Chapter 4). Chuck has been engaged in
the business of farming for the past four years and worked part-time as a
plumber for the past three years. Chuck’s creditors discharged $455,000 of debt
related to his farming business in year 1 and subsequently issued a Form 1099-
C. Chuck did not file for bankruptcy and he is solvent. Chuck qualified to
exclude CODI under the qualified farm indebtedness exclusion.
(4) Other facts include:
• His farming gross receipts for the preceding three years were $180,000
and gross receipts for the preceding three years from his plumbing
business were $7,500.
• Debt immediately before the discharge was $258,953.
• A net operating loss was $75,433 in year 1.
• Total adjusted bases in qualified property at the beginning of year 2 was
$350,000.
(5) Two requirements must be met under IRC § 108(g)(2), for indebtedness to
qualify as qualified farm indebtedness. First, the indebtedness must have been
28
incurred directly in connection with the business of farming. In this example, the
discharged debt related to Chuck’s farming business.
(6) Secondly, fifty percent or more of the taxpayer's aggregate gross receipts for
the three taxable years preceding the taxable year of the discharge, must have
been attributable to the trade or business of farming.
(7) Chuck’s aggregate farming gross receipts of $180,000 for the three preceding
years is more than fifty percent of aggregate gross income. Fifty percent of
$180,000 is $90,000 ($180,000 gross receipts multiplied by fifty percent).
(8) Further, the excluded income cannot exceed the sum of the adjusted tax
attributes of the taxpayer plus the aggregate adjusted bases of qualified
property held by the taxpayer as of the beginning of the taxable year following
the taxable year of the discharge.
(9) In this example, Chuck was discharged of $455,000 of debt. The amount
excluded is limited to $425,433 ($75,433 adjusted tax attribute (NOL) plus
$350,000 aggregate adjusted bases of qualified property). Cancellation of debt
income reportable in gross income was $29,567 ($455,000 discharged debt
minus $425,433 CODI limitation).
(10) Under IRC § 108(g)(3), excluded income is limited to $425,433. The remaining
$29,567 of canceled qualified farm debt should be included as farming income
subject to employment tax on the Form 1040, Schedule F for year 1, as other
income.
C.2. Examination Consideration
(1) The farm exclusion is NOT an election. Although, Form 982 is used to report
the exclusion type, amount of CODI excluded from gross income, and the tax
attribute reduction, it is not required to be filed with a tax return for the farm
exclusion. Failure to attach a Form 982 to a tax return for the farm exclusion
does not prevent a taxpayer from excluding cancellation of debt income from
gross income. As such, a taxpayer can present documentary evidence for
consideration during an examination. An examiner should gather all necessary
documents and develop relevant facts to determine whether a taxpayer meets
the farm exclusion.
D. Qualified Real Property Business Indebtedness
(1) A taxpayer (other than a C Corporation) may elect to exclude CODI from
discharged qualified real property business indebtedness under IRC §
108(a)(1)(D). An eligible taxpayer must make a valid election on a timely filed
return (including extensions), to exclude discharged qualified real property
business debt from income, by attaching Form 982 to the tax return. A taxpayer
may file a late election if an amended tax return is filed within six months of the
29
due date of the return (excluding extensions) under Treas. Reg. § 301.9100-2.
If an election is not made timely or with an amended return filed within six
months of the due of the return, a taxpayer must request permission to file a
late election.
(2) In PLR 201316009, 2013 WL 1699430, a taxpayer filed a timely individual tax
return in year 1. The taxpayer was a 50-percent partner in a LLC that received
cancellation of debt income related to qualified real property business
indebtedness. The LLC failed to identify the type of cancellation of debt income
and the individual’s tax preparer treated the CODI as other income. It was not
until year 3 when the tax preparers realized that the taxpayer was eligible to
exclude cancellation of debt income under the qualified real property business
indebtedness exclusion. The taxpayer subsequently filed a request for an
extension to file a late election. The IRS allowed the taxpayer to file an
amended return in order for the individual to make the election under Treas.
Reg. § 301.9100-3(c)(1).
(3) An eligible taxpayer can make this election to exclude CODI and reduce the
basis of depreciable real property by the amount of discharged qualified real
property business indebtedness. To qualify for this exclusion, IRC §
108(c)(3)(A) requires that the real property must be “used in a trade or
business.” Facts and circumstances must be considered in each case. Rental
real estate may qualify under this exclusion if the rental rises to the level of a
trade or business. However, the following situations may not qualify under this
exclusion.
• Generally, a taxpayer who is bankrupt or who is insolvent is not eligible for
this exclusion, as shown in Table 2, Order and Coordination of Exclusions,
discussed earlier. However, a taxpayer may qualify for more than one
exclusion.
• Generally, farm indebtedness does not qualify for the qualified real
property business indebtedness exclusion, as shown in Table 2, Order
and Coordination of Exclusions, discussed earlier.
• Generally, a rental is not a trade or business. Holding property for the
production of rents does not necessarily constitute a trade or business for
purposes of IRC § 162.
(4) PLR 9426006, 1994 WL 312382 states, “…a rental of even a single property
may constitute a trade or business under various Internal Revenue Code
provisions…However, the ownership and rental of real property does not, as a
matter of law, constitute a trade or business. Curphey v. Commissioner, 73 T.C.
at 766 (1980) The issue is ultimately one of fact in which the scope of a
taxpayer's activities, either personally or through agents, in connection with the
30
property, are so extensive as to rise to the stature of a trade or business.”
Bauer v. Commissioner, 168 F.Supp. 539, 541 (Ct.Cl.1958).
(5) Qualified real property business indebtedness is defined as indebtedness that
meets all of the following requirements:
• The debt was incurred or assumed by the taxpayer in connection with real
property used in a trade or business and is secured by such real property.
• It was incurred or assumed before January 1, 1993, or, if it was incurred or
assumed after such date, it is "qualified acquisition indebtedness”.
• It is indebtedness with respect to which the taxpayer makes an election to
have it treated as qualified real property business indebtedness.
(6) IRC § 108(c)(4) defines qualified acquisition indebtedness as, with respect to
any real property used in a trade or business, indebtedness secured by such
property and incurred or assumed to acquire, construct, reconstruct or
substantially improve such property. Qualified real property business
indebtedness can include land used in a trade or business. Qualified real
property business indebtedness includes refinanced debt, but only to the extent
that the refinanced debt does not exceed the debt being refinanced.
(7) There are two limitations, (1) the debt in excess of value and (2) the overall
limitation on the amount of discharged qualified real property business debt that
can be excluded from gross income under IRC § 108(c)(2) and further
described in Treas. Reg. § 1.108-6.
(8) In applying the first limitation, the amount of qualified real property business
indebtedness excludible from gross income cannot exceed the excess of the
outstanding principal amount of the qualified real property business debt
(immediately before the discharge) over the fair market value (immediately
before the discharge) of the business real property that secures the discharged
debt, less, the outstanding principal amount of any other qualified real property
business debt that secures the property immediately before the discharge.
(9) In applying the second or overall limitation, the excluded debt amount should
not be more than the aggregate adjusted bases of depreciable real property
held immediately before the discharge, (excluding depreciable real property
acquired in contemplation of the discharge) reduced by the sum of depreciation
claimed for the taxable year that CODI was excluded under this exclusion plus,
reductions to the adjusted bases of depreciable real property required under
IRC § 108(b) (e.g., bankruptcy or insolvency exclusions) for the same taxable
year plus, reductions to the adjusted bases of depreciable real property
required under IRC § 108(g), the qualified farm exclusion, for the same taxable
year.
31
D.1. Example
(1) Example 11 (Part I of Example 25, Chapter 4). Peter bought a grocery store
in year 1 that he operated as his sole proprietorship. Peter made a $25,000
down payment and financed the remaining $250,000 of the purchase price with
a bank loan. The bank loan documents indicated that it was a recourse loan,
secured by the property. Peter had no other debt secured by that depreciable
real property. In addition to the grocery store, Peter owned depreciable
equipment and furniture with an adjusted basis of $76,000.
(2) Peter’s business encountered financial difficulties in year 6. In year 7, Peter was
approved for a loan modification with the lender and $25,000 of the outstanding
balance of the debt was canceled.
(3) Other facts, immediately before the cancellation of debt include the following:
• Peter was not bankrupt and he was not insolvent
• Outstanding principal balance on the grocery store loan was $195,000
• FMV of the store was $172,000
• Adjusted basis of the store was $227,161
• The bank sent Peter a Form 1099-C for year 7. There was no information
in boxes 3, 5, 6 or 7, $25,000 was reported in Box 2
(4) Before the qualified real property business is considered, Peter must first
determine whether he qualifies to exclude CODI under the bankruptcy and
insolvency exclusions. In this case, Peter does not qualify for either exclusion
and may proceed with the qualified real property business exclusion.
(5) Peter looks to the limitations under the qualified real property business
indebtedness exclusion for the CODI of $25,000. The debt in excess of value
limitation was $23,000 ($195,000 outstanding loan amount immediately before
the discharge minus $172,000 fair market value of the property). Peter did not
have an outstanding principal amount of any other qualified real property
business debt secured by the property.
(6) The amount of excluded debt cannot exceed the overall limitation of $220,286
($227,161 aggregate adjusted bases of depreciable real property held before
the discharge minus $6,875 depreciation claimed in the year of discharge).
Peter did not have any basis reductions made under IRC § 108(b) or IRC §
108(g) for the same taxable year.
32
(7) Peter’s CODI exclusion of $23,000 for year 7 is limited to the overall limitation of
$220,286. The overall limitation is more than the exclusion limitation amount
therefore; $23,000 can be excluded from Schedule C gross income under the
qualified real property business indebtedness exclusion. Peter would report
$2,000 ($25,000 CODI minus $23,000 Limitation) as other income on his
Schedule C for year 7.
(8) For year 7, Peter would complete Form 982 with a check on line 1d (qualified
real property indebtedness exclusion), enter $23,000 on line 2 (total excluded
from gross income), and enter $23,000 on line 4 (amount of qualified real
property business basis reduction). Other income (subject to self-employment
tax) of $2,000 would be reported on Schedule C.
D.2. Examination Consideration
(1) The qualified real property business exclusion is an election by attaching a
Form 982 to a timely filed tax return (excluding extensions) or an amended
return filed within six months of the due date of the tax return (excluding
extensions). Failure to do so disqualifies the taxpayer from excluding
cancellation of debt income from gross income under this exclusion. As such, a
taxpayer must make a formal request for a Private Letter Ruling when the
taxpayer later discovers that he/she qualifies for this exclusion during an
examination. The examiner cannot make the determination when the taxpayer
did not make a timely election.
E. Qualified Principal Residence Indebtedness
(1) The qualified principal residence indebtedness (QPRI) exclusion under IRC §
108(a)(1)(E) generally allows taxpayers to exclude income from the discharge
of debt secured by their principal residence. Debt reduced through mortgage
restructuring, as well as mortgage debt forgiven in connection with a
foreclosure, qualifies for the relief under IRC § 108(a)(1)(E). Other rules must
be met, as well as the reduction of basis as discussed later.
(2) The Mortgage Debt Relief Act of 2007 was enacted to assist taxpayers with
their financial difficulties regarding their principal residence mortgage debt. This
provision has been extended and modified throughout the years. As such, IRC
§ 108(a)(1)(E) applies to debt forgiven on or after January 1, 2007 through
December 31, 2025 or, subject to an arrangement that is entered into and
evidenced in writing before January 1, 2026.
(3) IRC § 108(h)(2) defines qualified principal residence indebtedness as
acquisition indebtedness within the meaning of IRC § 163(h)(3)(B), except that
the limitation on the amount of qualified principal residence indebtedness is
$750,000 ($375,000 in the case of a married individual filing a separate return),
after December 31, 2020, and determined without regard to the substitution
33
described in IRC § 163(h)(3)(F)(i)(II). Acquisition indebtedness is further defined
as indebtedness incurred in acquiring, constructing or substantially improving
any qualified residence of the taxpayer that is secured by the residence and
indebtedness incurred in refinancing such indebtedness as long as the
refinanced indebtedness does not exceed the original indebtedness.
(4) IRC § 108(h)(5) states that a “principal residence” has the same meaning as it
does in IRC § 121. IRC § 121 does not define the term “principal residence”, but
states that gross income does not include gain on the sale of property if a
taxpayer owned and used it as his principal residence at least two of the prior
five years (5-year look-back test).
(5) Treas. Reg. §§ 1.121-1(b)(1) and (2) define the terms “residence” and “principal
residence”. Under Treas. Reg. § 1.121-1(b), whether a property is a taxpayer’s
principal residence is based on all of the facts and circumstances, including the
taxpayer’s use of the property and other factors, including the address listed on
the taxpayer’s federal and state tax returns, driver’s license, and the taxpayer’s
mailing address.
(6) In 2005 and thereafter, the United States experienced a surge in the number of
homeowners losing their principal residences to foreclosures. Legislative intent
of IRC § 108(a)(1)(E) was to assist homeowners who would have had to
otherwise pay substantial amount of tax on cancellation of debt income. As
such, the definition of principal residence does not include the 5-year look-back
test when determining whether a taxpayer qualifies to exclude cancellation of
debt income under the qualified principal residence exclusion in IRC §
108(a)(1)(E). In other words, a taxpayer is not required to have owned and used
a residence as his/her principal residence for a minimum of two years.
However, the examiner should identify the facts and circumstances and other
factors to determine whether the residence was in fact the taxpayer’s principal
residence prior to the foreclosure. The 5-year look-back test ownership and use
requirements apply only when determining whether the taxpayer may exclude
from income any gain on the sale (including a foreclosure sale) of the residence
under IRC § 121.
(7) For example, if a taxpayer lived in his principal residence for only a year and
then moved out of the residence strictly due to the decline in the value of his
home and foreclosure proceedings, the disposition may be considered the
taxpayer’s principal residence at the time of foreclosure, based on these facts
alone. See Example 12, Example 13, and Example 17, discussed later.
E.1. Indebtedness That Does Not Qualify
(1) The exclusion does not apply if the discharge is due to services performed for
the lender or any other reason not directly related to a decline in the home’s
value or the taxpayer’s financial condition. Where the debtor is employed by the
34
lender, and the discharge of indebtedness relates to employment services
performed, the discharge will not qualify for the exception. In addition, the
exclusion doesn't apply to debt forgiven on second homes, business property,
rental property, credit cards, or auto loans. Refer to Publication 4681, Canceled
Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), for
more information.
(2) The qualified principal residence indebtedness exclusion only applies to
acquisition debt. If a loan is discharged in whole or in part and only a portion of
the loan is qualified principal residence indebtedness, the exclusion will be
applied only to the part of the loan that is qualified acquisition debt, as
determined immediately before the discharge. In other words, the amount of the
CODI excluded must be the debt that was used to acquire, construct, or
substantially improve the principal residence.
E.2. Examples
(1) Example 12. Jacob owns two residences, one in Arizona, and one in Texas.
From year 1 through year 6, he lived in the Arizona residence for 7 months and
the Texas residence for 5 months of each year. Both homes were foreclosed
and sold by the lender in January of year 7. The lender forgave the taxpayer of
the outstanding debt balances on both homes. Which home would qualify under
the principal residence exclusion?
(2) In the case of a taxpayer using more than one property as a residence, the
residence that the taxpayer uses the majority of the time during the year will
ordinarily be considered the taxpayer’s principal residence. The principal
residence will depend on all facts and circumstances. Treas. Reg. § 1.121-1(b).
In the absence of facts and circumstances indicating otherwise, the Arizona
residence is Jacob's principal residence. The CODI from the Texas home would
be reported as other income unless he qualified for another exclusion. In
addition, he would be eligible for the IRC § 121 exclusion of gain from the sale
or exchange of the Arizona residence, but not the Texas residence. Any gain
realized from the Texas home would be reported on Form 8949, Sales and
Other Dispositions of Capital Assets and Schedule D, Capital Gains and
Losses.
(3) Example 13. Caroline owns two residences, one in Washington and one in
California. During years 1 and 2, she lived in the Washington residence. During
years 3 and 4, she lived in the California residence. During year 5, she lived in
the Washington residence. Caroline's principal residence during years 1, 2, and
5 is the Washington residence. Caroline’s principal residence during years 3
and 4 is the California residence. She would be eligible for the IRC § 121
exclusion of gain from the sale or exchange of either residence (but not both)
during year 5. Theoretically, Caroline would also be allowed to exclude
35
cancellation of debt income under the qualified principal residence exclusion
from the same primary residence, but not both.
(4) Example 14. Joanne purchased her principal residence property for $100,000
paying $20,000 cash and securing a mortgage loan (recourse debt) of $80,000.
When the mortgage balance was $72,000, Joanne defaulted and the property
was sold at foreclosure for $68,000.
(5) If the liability was discharged before 2007, then Joanne had cancellation of
indebtedness income of $4,000 ($72,000 mortgage balance minus $68,000
FMV of the property) and a nondeductible capital loss of $32,000 ($68,000 FMV
of the property minus $100,000 adjusted basis of the property). If the liability is
discharged after 2006, but before January 1, 2026, Joanne can exclude the
cancellation of indebtedness income of $4,000 per IRC § 108(a)(1)(E) and she
has a nondeductible capital loss of $32,000 ($68,000 FMV of the property
minus $100,000 adjusted basis of the property).
(6) Example 15. Because of non-payment of a recourse mortgage, the lender
foreclosed on Jack’s principal residence and he later received government
relocation assistance of $1,500. At the time of the foreclosure sale, Jack’s basis
in the home was $245,000, the home's FMV was $255,000, and the outstanding
amount of mortgage debt (first and second) on the home was $220,000.
(7) Cancellation of debt income is zero ($220,000 debt balance immediately before
the foreclosure minus $255,000 the FMV of the property). Peter’s realized loss
from the foreclosure was $23,500 ($220,000 outstanding debt balance plus
$1,500 relocation assistance minus $245,000 adjusted basis of the property).
(8) The rationale of limiting the amount realized to the debt balance is because
Jack did not receive any proceeds from the foreclosure sale. The property was
Jack’s principal residence. Thus, the disposition would be reported on Form
8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital
Gains and Losses as a nondeductible personal loss.
(9) Example 16. Dan acquired his primary residence for $300,000 in year 1. He
refinanced the loan in year 5 for $320,000 and used $20,000 to pay off personal
credit cards and car loans. In year 7, when the mortgage principal balance was
$290,000, he was unable to make the monthly payments and he did not qualify
for any mortgage restructuring programs. The lender ultimately foreclosed on
the property in year 9 and issued a Form 1099-A indicating a market value of
$350,000. The foreclosure sale did not occur until year 10 for $155,000. The
taxpayer did not report the disposition on any of his tax returns. The taxpayer’s
tax return for year 9 was selected for examination.
(10) If the loan was nonrecourse, the disposition should have been reported in year
9, the year that the lender foreclosed on the property. The foreclosure ended
36
the taxpayer’s financial obligation and ownership. In other words, the
foreclosure satisfied the taxpayer’s debt.
(11) The amount realized for nonrecourse notes is the greater of the fair market
value (FMV) of the property or the outstanding loan amount. The realized gain
in year 9 was $50,000 ($350,000 FMV of the property minus $300,000 adjusted
basis). Under IRC § 121 Dan would not recognize the $50,000 gain.
(12) The case file should document the facts that led up to the foreclosure and other
pertinent information. The disposition of the primary residence should have
been reported on Form 8949 even though the loss is not deductible. For more
details, see Nondeductible Losses in the Schedule D (Form 1040) Instructions.
(13) Assume the facts are the same except the loan was recourse. Additional facts
include that in year 10, the court awarded a deficiency judgment to the lender
for $75,000. The deficiency judgment is the amount of the outstanding loan that
the taxpayer is personally liable to pay.
(14) The taxpayer was not required to pay any outstanding debt in excess of
$75,000. The lender is not required to file and issue a Form 1099-C until year
11. Dan did not report the disposition on any of his returns or attach a Form 982
for the canceled debt.
(15) The cancellation of debt income in year 10 was $60,000 ($290,000 outstanding
debt balance minus $155,000 foreclosure sale amount (FMV) minus $75,000
deficiency judgment). Since the loan was recourse, the disposition should be
reported in year 10, the year of the foreclosure sale and resolution of the
recourse note. The nondeductible loss in year 10 was $145,000 ($155,000 FMV
minus $300,000).
(16) Dan had a responsibility to report canceled debt income or exclude canceled
debt income from gross income and file Form 982 with his tax return whether or
not he received a Form 1099-C. During the examination, the taxpayer stated
that he qualified to exclude the entire $60,000 from gross income under the
qualified principal residence exclusion. Dan presented documentation that
proved that the foreclosed property was his principal residence and the
outstanding loan balance was qualified principal residence indebtedness.
(17) Because the qualified principal residence is not an election, failure to file Form
982 with the return does not prevent the taxpayer from presenting
documentation during an examination. Based on the facts and circumstances,
the examiner did not make an adjustment to include $60,000 in gross income.
(18) Example 17. Amy signed a recourse loan to purchase her principal residence.
Shortly after she purchased the home, she was laid off and unable to pay the
mortgage. She subsequently entered into a short sale agreement with the
lender and sold the home. This was her principal residence for one year. At the
37
time of the sale, Amy’s basis in the home was $170,000, the home's FMV was
$200,000, and the outstanding amount of the mortgage debt was $220,000.
Amy received $8,000 for relocation assistance through a government program.
(19) The cancellation of debt income was $20,000 ($220,000 outstanding debt
balance immediately before the discharge minus $200,000 fair market value).
Amy’s tax preparer excluded the $20,000 cancellation of debt income from
gross income under the principal residence exclusion. A Form 982 was not filed
with the tax return.
(20) The gain realized from the disposition was $38,000 ($200,000 short sale (FMV)
plus $8,000 relocation assistance minus $170,000 adjusted basis). The tax
preparer excluded the $38,000 gain under IRC § 121.
(21) Amy’s tax return was selected for examination. The examiner correctly
determined that although, a Form 982 was not filed with the return that Amy
qualified to exclude the $20,000 CODI from gross income under the qualified
principal residence exclusion in IRC § 108(a)(1)(E). No adjustment was made to
this issue.
(22) Although, the property was Amy’s principal residence, she did not meet the two
out of five year test in IRC § 121 and the disposition gain is taxable. The
examiner made an adjustment and included the $38,000 gain in income from
the short sale of Amy’s principal residence.
E.3. Other Tax Considerations
(1) Closing Costs - An important consideration with respect to refinanced qualified
principal residence indebtedness is closing costs. This can also occur with “zero
down” first mortgages. Often closing costs are rolled into the loan. The
refinanced debt that qualifies is limited to the amount of the old mortgage
principal. Therefore, closing costs from the refinancing are not includable in the
principal residence debt relief exclusion. They are includable in income, unless
the taxpayer qualifies under a different exclusion.
(2) Exclusion of Gain - In addition to the exclusion of cancellation of debt income,
a taxpayer may also exclude any gain recognized from the disposition of their
principal residence under IRC § 121. Gain can only be excluded on one
qualified principal residence every two years under IRC § 121(b)(3) and the
taxpayer must meet the 2 year out of 5-year rule under IRC § 121(a). Note that
some taxpayers lost their homes before living in them for two years or the
homes were not their principal residence for 2 out of 5 years. Under these
circumstances, any gain from the disposition is taxable.
38
E.4. Examination Consideration
(1) The principal residence exclusion is NOT an election. Although, Form 982 is
used to report the exclusion type, amount of CODI excluded from gross income,
and the tax attribute reduction, it is not required to be filed with a tax return for
the principal residence exclusion. Failure to attach a Form 982 to a tax return
does not prevent a taxpayer from excluding cancellation of debt income under
the insolvency exclusion. As such, a taxpayer can present documentary
evidence for consideration during an examination. An examiner should gather
all necessary documents and develop relevant facts to determine whether a
taxpayer meets the principal residence exclusion.
E.5. Audit Techniques
(1) If the loan balance is in question, review property records, foreclosure notices,
loan statements, loan documents, etc. to determine the loan balance right
before the disposition.
(2) Request the final closing statement for the foreclosure, short sale, or deed in
lieu of foreclosure. Keep in mind that the taxpayer may not have received the
final closing statement. In addition, the final closing statement may not identify
the total loan balances right before the disposition. It normally will only include
the loan amount that the sales proceeds satisfied. Therefore, the loan amounts
on the Final Closing Statement plus the cancellation of debt income may equate
to the outstanding loan balance right before the disposition.
(3) Request the Final Closing Statement for short sales, deed in lieu of
foreclosures, and loan modifications. There are a few federal, state, local
government, and lender incentives that the taxpayer may have qualified for that
would appear on the Final Closing Statement. These incentives are generally
taxable and included in the amount realized. For example, a taxpayer may
receive funds to cover their relocation expenses. This may be listed on the Final
Closing Statement as “relocation assistance”. This amount generally is taxable
and should be included in the sales price on Schedule D or Form 4797.
(4) Identify whether the real estate property was refinanced or if there is a line of
credit. Any use of these funds that were not used to buy, build or improve on
the principal residence is not acquisition indebtedness and this portion of the
CODI may be taxable.
IV. Tax Attribute Reduction
A. Reduction of Tax Attributes
(1) When cancellation of debt income is excluded from income under IRC §
108(a)(1), tax attributes are generally reduced (but not below zero) by the
39
amount of cancellation of debt income excluded. The reduction in tax attributes
defers the tax treatment rather than eliminate CODI. The taxpayer files Form
982 to report the exclusion of CODI and the reduction of tax attributes. If the
excluded CODI exceeds the sum of the taxpayer’s tax attributes, the excess is
permanently excluded from the taxpayer’s gross income (Treas. Reg. § 1.108 -
7(a)(2)) as illustrated in Example 22. Each exclusion has its own tax attribute
reduction rules that are discussed in this section.
(2) IRC § 108(b) prescribes how and in what order tax attributes must be reduced,
for the bankruptcy, insolvency, and farm exclusions. The farm indebtedness
exclusion requires two calculations to determine the amount to reduce tax
attributes. Once specific rules of the qualified real property business exclusions
are applied, basis will be reduced in accordance with IRC § 108(c) and IRC §
1017. See Table 3, Tax Attribute Reduction Rules, discussed later.
(3) IRC § 108(b) does not apply to the qualified principal residence exclusion. The
qualified principal residence exclusion only requires a reduction in basis (but not
below zero) of the principal residence when the taxpayer continues to own the
property after debt is canceled (e.g., loan modification) as prescribed in IRC §
108(h). See Table 3, Tax Attribute Reduction Rules, discussed later.
(4) Any assets disposed of during the taxable year when debt is discharged are not
subject to basis reduction under IRC § 108(b)(2)(E), with the exception of the
qualified real property business indebtedness exclusion, discussed later. If the
sale of an asset gives rise to an unused ordinary or capital loss (e.g., it creates
or adds to a net operating or capital loss), that loss is subject to reduction under
IRC § 108(b)(2)(A) for net operating loss or IRC § 108(b)(2)(D) for capital loss
carryover.
(5) The basis reductions under IRC § 108(b)(2)(E) are accomplished under
ordering rules set forth in Treas. Regs. § 1.1017-1(a) for bankruptcy and
insolvency exclusions. Again, the other exclusions have different basis
reduction rules. The ordering rules require a reduction (but not below zero) in
the following order, to the extent of excluded cancellation of debt income. The
reduction to bases of property is made on the first day of the following year that
the taxpayer excluded CODI from gross income (in proportion to adjusted
basis):
• Real property used in a trade or business or held for investment (other
than IRC § 1221(a)(1) real property, held for sale to customers in the
ordinary course of business) that secured the discharged indebtedness
immediately before the discharge;
• Personal property used in a trade or business or held for investment, but
not inventory, accounts receivable, or notes receivable, that secured the
indebtedness immediately before the discharge;
40
• Remaining property used in a trade or business or held for investment, but
not inventory, accounts receivable, notes receivable, or IRC § 1221(a)(1)
real property, held for sale to customers in the ordinary course of
business;
• Inventory, accounts receivable, notes receivable, and IRC § 1221(a)(1)
real property, held for sale to customers in the ordinary course of
business; and
• Property not used in a trade or business nor held for investment.
• Reductions in basis on account of the exclusion from gross income of
discharge of indebtedness income are not treated as dispositions of the
property (IRC § 1017(c)(2)).
A.1. Election to Reduce Basis First
(1) In lieu of following the tax attribute reduction ordering rules in IRC § 108(b), a
taxpayer may make an election under IRC § 108(b)(5) to reduce the basis in
depreciable property first, before reducing other tax attributes. The taxpayer
may elect to apply any amount of the CODI excluded from income to reduce
basis. The election to reduce basis first may be made for all exclusions except
for the qualified real property business exclusion and the qualified principal
residence exclusion. The taxpayer makes an election by attaching Form 982 to
their tax return in the year of discharge and completing Part II, line 5.
Depreciable property can both be trade or business or held for investment
(rental). It can also be real or personal property. The key is that it must be
depreciable.
(2) IRC § 1017 describes how basis of depreciable property should be reduced.
Any excess CODI after basis is reduced is applied in the order or manner
prescribed for the specific exclusion, as applicable, and then IRC § 108(b). The
basis reduction is limited to the aggregate adjusted bases of the depreciable
property held by the taxpayer as of the beginning of the taxable year following
the taxable year of discharged debt.
A.2. Election to Treat Certain Inventory as Depreciable Property
(1) As discussed earlier, the basis reductions under IRC § 108(b)(2)(E) are
accomplished under ordering rules set forth in Treas. Reg. § 1.1017-1(a) for
bankruptcy and insolvency exclusions. The bases of the fourth type of property
reduced are inventory, accounts receivable, notes receivable, and IRC §
1221(a)(1) real property, held for sale to customers in the ordinary course of
business. IRC § 1017(b)(3)(E) allows a taxpayer to make an election to treat
certain inventory as depreciable property, which includes real property
described in IRC § 1221(a)(1).
41
(2) The election is made on Form 982, Part I, line 3. The election may be revoked
only with the consent of the Secretary. The election is not available for the
qualified real property business exclusion. Application of this election is not
discussed in this guide.
A.3. Depreciation Recapture Reductions
(1) There is no depreciation recapture for IRC § 1250 property for which ACRS or
MACRS depreciation deductions are computed using the straight-line method
under IRC § 1017(d). Depreciation taken in excess of straight-line depreciation
must be recaptured as ordinary income.
(2) Property that is neither IRC § 1245 or IRC § 1250 property is treated as IRC §
1245 property. Any tax attribute, basis reduction for property treated as section
1245 property is treated as if the reduction was from depreciation under IRC §
1017(d)(1)(B).
(3) IRC § 1245 property is defined as any property which is or has been property of
a character subject to the allowance for depreciation provided in IRC § 167 and
is either personal property, other property, real property, single purpose
agricultural or horticultural structure, storage facility, or any railroad grading or
tunnel bore.
(4) IRC § 1250 property is defined as any real property other than § 1245 property
which is or has been property subject to the allowance for depreciation provided
in IRC § 167, for example, rental property. Under a special rule for IRC § 1250
property, when determining whether there is excess depreciation for IRC §
1250 depreciation recapture, basis reductions under IRC § 1017 are ignored
(IRC § 1017(d)(2)). In other words, excess depreciation is determined without
consideration of IRC § 1017 basis reduction.
A.4. Summary of Tax Attribute Reduction Rules
(1) Table 3, Tax Attribute Reduction Rules, is a summary of the primary and
secondary Internal Revenue Code sections applicable for each exclusion’s tax
attribute reduction rules. Although, a Form 982 should be attached to a timely
filed return to report the type of exclusion(s) and amount of CODI excluded from
income, the qualified real property business exclusion is the only exclusion that
is an election where a Form 982 is required. Under IRC § 108, a taxpayer may
make certain elections where a Form 982 or a statement is required to be
attached to a timely filed return. For example, a Form 982 is required to make
the election to reduce basis first and to make the election to treat certain
inventory as depreciable property.
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(2) Table 3. Tax Attribute Reduction Rules
Exclusion
Primary Attribute
Reduction Rules
Secondary
Attribute
Reduction Rules
Form 982
Required?
Bankruptcy
IRC § 108(b)
IRC § 108(d)(8)
IRC § 1017(b)(2)
No
Insolvency
IRC § 108(b)
IRC § 1017(b)(2)
No
Farming
IRC § 108(g) First,
determine
limitations &
excludable
amount
IRC § 108(b)
IRC § 1017(b)(4)
only basis of
qualified property
is reduced
No
Real Property
Business
IRC § 108(c)(2)
First, determine
limitations &
excludable
amount
IRC § 108(c) basis
of depreciable real
property IRC §
1017(b)(3)
Yes
Principal Residence
IRC § 108(h)(1)
none
No
Bankruptcy,
Insolvency, &
Farming
IRC § 108(b)(5) &
IRC § 1017(a)
Election to first
reduce
depreciable
property held at
the beginning of
the following year
of discharge
IRC § 108(b)
Yes
All exclusions
except, Real
Property Business
and Principal
Residence
IRC §
1017(b)(3)(E)
Election to treat
certain inventory
as depreciable
property
IRC § 108(b)
Yes
(3) Failure to attach a Form 982 to a tax return for the bankruptcy, insolvency, farm,
and principal residence exclusions does not prevent a taxpayer from excluding
cancellation of debt income from gross income. As such, a taxpayer can
present documentary evidence for consideration during an examination. An
examiner should gather all necessary documents and develop relevant facts to
determine whether a taxpayer meets the exclusion(s).
43
(4) Keep in mind that a taxpayer may qualify for more than one exclusion at one
time. If that is the case, the exclusion that has precedence is applied first thus,
multiple attribute reduction rules may apply. See Example 24 and Example 25.
(5) As stated earlier, IRC § 108(b) prescribes the type and order of tax attributes
that should be reduced at the beginning of the following year of discharge.
Certain tax attributes are reduced dollar for dollar and other tax attributes are
reduced by 33 1/3 cents per dollar. As shown in Table 4, Order and Timing of
Tax Attributes, within the order of reduction, most attributes that exist after the
computation of taxable income for the year of discharge are reduced. Other
attributes that exist in the beginning of the following year of discharge are
reduced.
(6) IRC § 108(b)(4) prescribes the ordering rules for tax attributes. IRC §
108(b)(4)(B) and (C) prescribe the order of carryovers. Losses in the year of
discharge are reduced first and then any carryovers into the year of discharge
are reduced. See Table 4, Order and Timing of Tax Attributes.
(7) Table 4. Order and Timing of Tax Attributes
Order Reduced - IRC § 108(b)
Year Reduced
NOL - current & carryovers
Year of discharge, then oldest year
General business credits
Year of discharge, then oldest year
Minimum tax credit
Following taxable year of discharge
Capital loss carryovers
Year of discharge, then oldest year
Basis in property
Following year of discharge
Passive activity loss & credits
Year of discharge
Foreign tax credit
Year of discharge, then oldest year
(8) Explanation of Table 4, Order and Timing of Tax Attributes:
• Reductions in tax attributes are made after the determination of tax for the
year of discharge. Losses and credits that exist after the determination of
tax are reduced first. Carryovers to or from the year of discharge that were
not applied in the determination of tax are then reduced. Bases in property
that are held on the first day of the taxable year following the year that
CODI is excluded are reduced.
• For example, a calendar year taxpayer was discharged of debt in year 2
and tax attributes listed in Table 4 existed on January 1 of year 3. On
January 1 of year 3, the taxpayer would first reduce year 2 net operating
loss and then the net operating loss carryover from year 1. See Chapter 4,
Example 21.
44
B. Bankruptcy, Insolvency, and Farm - Attributes Reduction
(1) Under IRC § 108(b)(4)(A), tax attributes are reduced after the determination of
tax for the year of discharge. As discussed earlier and in Table 4, Order and
Timing of Tax Attributes. IRC § 108(b) describes the type and order of attribute
reduction for the bankruptcy, insolvency, and qualified farm indebtedness
exclusions.
(2) Tax attributes under the qualified farm indebtedness exclusion are reduced in
the same manner as the bankruptcy and insolvency exclusions under IRC
§108(b), except for basis. Also, the farm indebtedness exclusion requires two
calculations to determine the amount to reduce tax attributes.
(3) Any reduction of basis arising from the income exclusion under IRC §
108(a)(1)(A) in a bankruptcy proceeding must be applied to property other than
property that is exempt property for purposes of the bankruptcy proceeding
(IRC § 1017(c)(1)).
(4) Any basis reduction under IRC § 108(b)(2)(E) for the bankruptcy or insolvency
exclusion is limited, as demonstrated in Example 20.
(5) Tax attributes are reduced in the following order in accordance with IRC §
108(b):
• A. Net operating loss. Net operating loss (NOL) is reduced by one dollar
for each dollar of excluded canceled debt. First, reduce any current year
NOL and then reduce any NOL carryover to the current year in the order
of the tax years from which the carryovers arose, starting with the earliest
year.
• B. General business credit. Any carryover to or from the taxable year of
discharge. A carryover is reduced by 33 1/3 cents for each dollar of
excluded canceled debt. For more information on the credit ordering rules,
refer to the instructions for Form 3800, General Business Credit.
• C. Minimum tax credit. Minimum tax credit available under IRC § 53(b) is
reduced by 33 1/3 cents for each dollar of excluded canceled debt as the
beginning of the taxable year immediately following the taxable year of
discharge.
• D. Net capital loss. Net capital loss is reduced by one dollar for each
dollar of excluded canceled debt. First, reduce any current year net capital
loss and then any capital loss carryover.
• E. Basis. Basis of any property held by the taxpayer at the beginning of
the taxable year following the taxable year of the discharge.
45
• F. Passive activity loss. Passive activity loss and credit carryovers under
IRC § 469(b) from the taxable year of the discharge. Credit carryovers are
reduced by 33 1/3 cents for each dollar of excluded canceled debt.
• G. Foreign tax credit carryovers. Any foreign tax credit carryover to or
from the taxable year of the discharge for the purposes of determining the
amount of the credit allowable under IRC § 27. Carryovers are reduced by
33 1/3 cents for each dollar of excluded canceled debt.
(6) Under IRC § 108(d)(8), a taxpayer who is discharged of debt in a Chapter 7 or
11 (e.g., bankruptcy) of title 11 of the United States Code to which IRC § 1398,
Rules relating to individuals’ title 11 cases, applies, the estate and not the
individual is treated as the taxpayer for discharged debt. Tax attribute reduction
is therefore made by the estate and not the individual, except for property that
the estate transfers to the individual. If basis reduction is required when the
discharge occurs in the final year of a bankruptcy estate, the reduction is made
in the basis of assets transferred to the debtor from the estate at the time the
property is transferred. No tax affect exists if a bankrupt taxpayer does not have
any attributes to reduce at the beginning of the year following the discharge.
B.1. Bankruptcy Attribute Reduction Examples
(1) Example 18 (Part II of Example 5, Chapter 3). Tara owed several creditors
and was no longer able to meet her financial obligations. As a result, she filed
for Chapter 7 bankruptcy and was granted a discharge of $174,678 of her debt
in year 1. Tara excluded the $174,678 from taxable income on her Form 1040,
year 1, return and attached Form 982 to report the exclusion.
(2) On Form 982 Part II, Tara elected to first reduce basis in depreciable property
held on January 1 of year 2, by $160,000, under IRC § 108(b)(5). The only
depreciable property owned was a residential rental property held for
investment. The adjusted basis after the discharge of debt on January 2 of year
2, was zero ($160,000 rental property adjusted basis on December 31 of year
1, minus $160,000 basis reduction on January 1 of year 2).
(3) CODI of $174,678 minus the basis reduction of $160,000 equals the remaining
amount of tax attributes that must be reduced by $14,678.
(4) The taxpayer elected to reduce basis first, therefore, the next step is to reduce
tax attributes in order under IRC § 108(b)(2). The tax attributes on January 1 of
year 2, included a Net operating loss (NOL) from year 1 for $3,000 and a
General business credit carryover from year 2 for $58,200.
(5) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount that each tax
attribute is reduced. For example, the NOL is reduced to the extent to which the
46
amount excluded from income does not reduce basis, and so on. Under IRC §
108(b)(1), the amount excluded from gross income shall be applied to reduce
tax attributes.
(6) Tax Attribute Reduction on January 1 of Year 2
Description
Attribute Reduction
CODI
Remaining CODI
174,678 less 160,000
equals
14,678
Minus NOL (Year 1)
3,000
CODI Balance
11,678
Minus General business
credit carryover (Year 1)
11,678
CODI Balance
0
(7) As shown in the table above, tax attributes are reduced by the amount of
cancellation of debt income excluded from gross income. The reduction to the
net operating loss is dollar for dollar and the reduction to the general business
credit carryover is computed as $11,678 multiplied by .3333 equals $3,892.
(8) Tax attribute balances on January 2 of year 2 for the net operating loss from
year 1 was zero ($3,000 minus $3,000) and the general business credit
carryover from year 1 was $54,308 ($58,200 less $3,892). Tara had no other
tax attributes subject to reduction under IRC § 108(b). Therefore, further
attribute reduction is not required. The Form 982 for year 1 is completed as
shown in the following table.
(9) Year 1 - Form 982 Parts 1 and II
Line
Number
Form Line Description Mark or
Amount
Line 1a
Discharge of debt in a Title 11 case
Mark an X
Line 2 Total amount of discharged debt excluded from
gross income
$174,678
Line 5
Election to reduce basis first
$160,000
Line 6
Net operating loss
$3,000
Line 12
General business credit carryover (Year 1)
$3,892
47
(10) Example 19. Gary was granted a discharge of $123,100 debt in bankruptcy
court for tax year ending December 31 of year 2. Taxable income was $45,000
before the use of a net operating loss carryover from year 1 of $109,969. Gary
qualifies to exclude CODI under IRC § 108(a)(1)(A), bankruptcy, and does not
elect to reduce basis first. Additional facts are shown below.
(11) Under IRC § 108(b)(4)(A), taxable income must first be determined to identify
the amount and type of attribute to reduce. The taxable income for year 2 was
zero ($45,000 taxable income before the NOL carryover from year 1 minus
$45,000 net operating loss deduction).
(12) Tax attributes that existed on January 1 of year 3, were the net operating loss
carryover of $ 64,969 ($109,969 minus $45,000), general business credit from
year 2 of $26,624, and a capital loss from year 2 of $31,507.
(13) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount of tax attributes
reduced. Under IRC § 108(b)(1) the amount excluded from gross income shall
be applied to reduce tax attributes.
(14) IRC § 108(b) - Tax Attribute Reduction on January 1 of Year 3
Description
Tax Attribute
CODI
CODI excluded from
income
$123,100
Minus NOL
64,969
CODI Balance
$58,131
Minus Gen. Bus. Credit
(Year 2)
26,624
CODI Balance
$31,507
Minus Capital Loss
(Year 2)
31,507
CODI Balance
$0
(15) The tax attribute balances on January 2 of year 3 for the NOL carryover from
year 2 was zero ($64,969 minus $64,969), the general business credit from
year 2 was $17,750 ($26,624 multiplied by .3333 minus $26,624), and the
capital loss from year 2 was zero ($31,507 minus $31,507).
(16) IRC § 108(b)(4) prescribes the ordering rules for tax attributes. IRC §§
108(b)(4)(B) and (C) prescribe the order of carryovers. Tax attributes in the year
48
of discharge are reduced first and then any carryovers into the year of
discharge are reduced. See Table 4, Order and Timing of Tax Attributes.
B.2. Insolvency Attribute Reduction Examples
(1) Example 20 (Part II of Example 6, Chapter 3). Ashley was unable to pay her
recourse mortgage for her second home after her divorce. She entered into a
deed in lieu of foreclosure agreement with the lender on October 1 of year 1
and was simultaneously forgiven of the outstanding debt. The bank
subsequently issued a Form 1099-C for $50,000 discharged debt.
(2) Ashley was insolvent by $30,260 ($756,589 total liabilities, includes mortgage of
second home, minus $726,329 total assets, (includes FMV of second home)).
The cancellation of debt income reported in gross income was $19,740
($50,000 debt forgiven minus $30,260 insolvent amount) for year 1.
(3) On January 1 of year 2, Ashley prepared the following table to figure her tax
attribute reduction. Tax attributes are reduced (but not below zero) by the
amount of CODI excluded from income. Keep in mind that Ashley no longer
owned her second home as of October 1 of year 1.
(4) On October 2 of year 1, the bases reduction is limited to $43,411 ($590,000
aggregate of bases of the property held by the taxpayer immediately after the
discharge (excludes second home) minus $546,589 aggregate of the liabilities
immediately after the discharge (excludes second home)) under IRC §
108(b)(2)(E) and IRC § 1017(b)(2).
(5) The tax attributes that existed on January 1 of year 2, was a capital loss from
year 1 of $2,000, basis in property owned (includes purchases of assets)
described in Treas. Reg. Treas. Reg. § 1.1017-1(a) of $610,000, and a passive
activity loss from year 1 of $19,000.
(6) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount of tax attributes
reduced. Under IRC § 108(b)(1) the amount excluded from gross income shall
be applied to reduce tax attributes.
49
(7) Tax Attribute Reduction on January 1 of Year 2
Description
Tax Attribute
CODI
CODI excluded from income
$30,260
Less Capital loss (Year 1)
2,000
CODI Balance
$28,260
Less Bases in Treas. Reg. § 1.1017-1(a)
property
28,260
CODI Balance
0
(8) Ashley reported $19,740 of the CODI as other income on her Form 1040 for
year 1 and excluded $30,260 from gross income under IRC § 108(a)(1)(B), the
insolvency exclusion. She attached Form 982 to her return. Form 982 would be
completed with a check mark on Form 982, line 1b (insolvency), $30,260 on line
2 (CODI excluded from income), $2,000 on line 9 (year 1 capital loss), and
$28,260 on line 10a (basis in depreciable and nondepreciable property).
(9) Tax attributes balances on January 2 of year 2 included the basis in Treas.
Reg. §1.1017 -1(a) property of $581,740 (610,000 minus $28,260), a PAL
carryover from year 1 of $19,000, and a zero balance of the capital loss from
year 1 ($2,000 minus $2,000).
(10) Example 21. Constance was unable to make her mortgage payments on her
second home and entered into a short sale agreement with the lender. The
property was sold on August 5 of year 2 and the lender forgave the remaining
outstanding debt of $112,753. Constance excluded cancellation of debt income
under the insolvency exclusion. Additional facts include:
• Insolvent immediately before the discharge by $120,000
• Net operating loss of $63,820 (Year 2)
• Capital loss of $3,312 (Year 2)
• Capital loss carryover of $2,970 (Year 1)
• Bases in property of $885,963
• Basis limitation-IRC §1017(b) of $10,000
• Passive activity loss of $97,963 (Year 2)
50
(11) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount of tax attributes
reduced. Under IRC § 108(b)(1) the amount excluded from gross income shall
be applied to reduce tax attributes.
(12) Tax Attribute Reduction on January 1 of Year 3
Description
Tax Attribute
CODI
CODI excluded from gross income
$112,753
Minus Net operating loss (Year 2)
63,820
CODI balance
48,933
Minus Capital loss (Year 2)
3,312
CODI balance
45,621
Minus Capital loss carryover (Year 1 -
unused in Year 2)
2,970
CODI balance
42,651
Minus Basis limitation-IRC § 1017(b)
10,000
CODI balance
32,651
Minus PAL (Year 2)
32,651
CODI balance
$0
(13) Constance would complete Form 982 for year 2 with a check mark on line 1b
Insolvency, line 2, CODI excluded of $112,753, line 6, NOL of $63,820, line 9,
capital loss of $6,282 (3,312 plus 2,970), line 10a, basis of $10,000, and line
12, PAL from year 2 of $32,651.
(14) The tax attribute balances as of January 2 of year 3, included bases in property
of $875,963 ($885,963 minus $10,000), a PAL carryover from year 2 of $65,312
($97,963 minus $32,651), an NOL from year 2 of zero (63,820 less 63,820),
and a capital loss carryover from year 2 of zero (6,282 less 6,282).
B.3. Other Considerations for Bankrupt or Insolvent Taxpayers
(1) What happens if a taxpayer is bankrupt or insolvent and does not have any tax
attributes to reduce other than personal-use property? If a taxpayer does not
have any tax attributes as previously discussed, the basis in personal-use
property held at the beginning of the year following the discharge is reduced.
Personal-use property would be property not used in a trade or business nor
held for investment such as a personal residence, home furnishings, car, etc.
51
(2) Basis reduction limitations prescribed in IRC § 1017(b)(2) and Treas. Reg. §
1.1017 -1(b)(3) apply to bankrupt or insolvent taxpayers. The total basis
reduction for all personal-use property is limited to one criterion described under
step 1 below. Once the basis limitation is determined, the basis in each
personal-use property is reduced in proportion to the total adjusted basis of the
personal-use property, described in step 2 below.
(3) Step 1: Step 1 is the basis reduction limitation which is the smallest of the
bases of personal-use property held at the beginning of the following year of
discharge or the amount of canceled non-business debt (other than qualified
principal residence indebtedness) that is excluded from income on Form 982
line 2 or the excess of the total bases of the property and the amount of money
held immediately after the cancellation over total liabilities immediately after the
cancellation.
(4) Step 2: Step 2 is the amount from step 1 multiplied by the basis of personal-use
property divided by the adjusted basis of all personal-use property equals the
amount of basis reduction for the respective property. See Example 22 for
further clarification.
B.4. Basis Example
(1) Example 22. Ayden’s second home was foreclosed, and the lender forgave
$105,000 of the debt after the sale. She is insolvent by $90,000 and she did not
have any tax attributes other than basis in personal-use property.
(2) Facts developed during the examination revealed that the bases of personal-
use property held at the beginning of the year following discharge was
$330,000, the amount of canceled non-business debt (other than qualified
principal residence indebtedness) that is excluded from income on Form 982
line 2 was $90,000, and the excess of the total bases of the property and the
amount of money held immediately after the cancellation over total liabilities
immediately after the cancellation was $10,000.
(3) Ayden reduced basis in personal-use property by $10,000, which is the smallest
of the three amounts. In addition, Form 982 is completed with a check box on
line 1b (insolvency), $90,000 on line 2 (amount of discharged debt), and
$10,000 on line 10a (basis reduction of nondepreciable and depreciable
property). The basis reduction limited to $10,000.
(4) Basis in personal-use property follows:
• Principal residence $300,000
• Furniture $13,300
52
• Automobile $15,200
• Jewelry $1,500
• Total property bases $330,000
(5) The basis in each personal property is reduced in proportion to the total
adjusted basis as shown in the following table:
(6) Basis Reduction Calculation
Description
Allocation Total
Principal
Residence
10,000 multiply by (300,000 divided by 330,000)
equals
9,091
Furniture
10,000 multiply by (13,300 divided by 330,000) equals
403
Auto
10,000 multiply by (15,200 divided by 330,000) equals
461
Jewelry
10,000 multiply by (1,500 divided by 330,000) equals
45
Total
10,000
(7) The basis in each personal property before and after the bases reduction is
shown in the following table:
(8) Adjusted Bases Balances after Reduction
Description
Adjusted
Basis
BEFORE
Reduction
Adjusted Basis
AFTER
Reduction
Principal
Residence
$300,000
$290,909
Furniture
$13,300
$12,897
Auto
$15,200
$14,739
Jewelry
$1,500
$1,455
Totals
$330,000
$320,000
(9) In summary, Ayden would report $15,000 as other income on Form 1040. She
excludes $90,000 from gross income. The exclusion is reported on Form 982 as
a check mark on line 1b (extent of insolvency), line 2 (excluded CODI) of
$90,000, and line 10a (nondepreciable property) of $10,000.
53
(10) In this example, CODI exceeds the sum of the tax attributes that are required to
be reduced by $80,000 (90,000 less 10,000). Per Treas. Reg. § 1.108-7(a)(2),
no further tax attribute reduction is required, and Ayden is not required to
include any of the $90,000 in income.
B.5. Qualified Farm Indebtedness - Basis Attribute Reduction
(1) As discussed earlier, tax attributes under the qualified farm indebtedness
exclusion are reduced in the same manner as the bankruptcy and insolvency
exclusions under IRC § 108(b), except for basis. Only basis of qualified property
is reduced under this exclusion. Qualified farm property is defined in IRC §
108(g)(3)(C) as any property used or held for use in a trade or business or for
the production of income.
(2) IRC § 108(b) provides the order in which the taxpayer must reduce tax
attributes when qualified farm indebtedness is excluded from income. IRC §
1017(b)(4)(A)(i) provides that only qualified property held by the taxpayer is
eligible for basis reduction due to the discharge of qualified farm indebtedness.
IRC § 1017(b)(4)(A)(ii) further provides that the basis of qualified property must
be reduced in the following order:
1. Depreciable qualified property
2. Land used or held for use in the trade or business of farming
3. Oher qualified property
(3) Example 23 (Part II of Example 10, Chapter 3). An overview of the facts from
Example 10 is:
• Chuck did not file for bankruptcy and he is solvent.
• $455,000 discharged debt related to Chuck’s farming business
• $425,433 CODI limitation
• $ 29,567 CODI reported in farming gross income
• Tax attribute on January 1 of year 2, includes an NOL from year 1 of
$75,433.
• Chuck did not elect to treat real property held primarily for sale to
customers as depreciable property.
(4) The basis of qualified property is reduced in the following order:
1. Depreciable qualified property of $200,000
2. Qualified land of $135,000
54
3. Other qualified property of $15,000
(5) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount of tax attributes
reduced. Under IRC § 108(b)(1) the amount excluded from gross income shall
be applied to reduce tax attributes.
(6) Attribute Reduction on January 1 of Year 2
Description
Tax Attribute
CODI
CODI excluded from
gross income
$425,433
NOL (Year 1)
75,433
CODI balance
350,000
Minus depreciable
qualified property
200,000
CODI balance
150,000
Minus qualified land
135,000
CODI balance
15,000
Minus other qualified
property
15,000
CODI balance
$0
(7) All tax attributes had a zero balance on January 2 of year 2, after the tax
attributes were reduced. The NOL carryover from year 1 was zero ($75,433
minus $75,433), the depreciable qualified property adjusted basis was zero
($200,000 minus $200,000), the qualified land adjusted basis was zero
($135,000 minus $135,000), and the other qualified property adjusted basis was
zero ($15,000 minus $15,000).
55
C. Qualified Real Property Business Indebtedness - Attribute
Reduction
(1) As discussed earlier, an eligible taxpayer can make an election to exclude
cancellation of debt income under the qualified real property business
indebtedness exclusion in IRC § 108(a)(1)(D). Under IRC § 108(c)(1) the
amount of CODI excluded under this exclusion is applied to reduce the basis of
the depreciable real property of the taxpayer. The term qualifying real property
means real property with respect to which the indebtedness is qualified real
property business indebtedness within the meaning of IRC § 108(c)(3).
(2) In applying basis reduction for the qualified real property business indebtedness
exclusion, IRC § 1017(b)(3)(F) is relied upon and basis reduction must first be
made to the property securing the debt that is canceled. Treas. Reg. §
1.1017-1(c)(1)). Furthermore, if the property is sold/foreclosed in the same year
as the debt cancellation, IRC §1017(b)(3)(F) requires that the basis reduction
be made immediately before the disposition. This will result in section 1250
recapture as ordinary income upon the deemed sale of the property. IRC §
1017(b)(3)(F)(iii)).
(3) Bottom line, if a taxpayer is able to exclude CODI under the qualified real
property business indebtedness exclusion in IRC §108(a)(1)(D), the taxpayer
must first reduce the basis of the property securing the debt that is discharged.
By reducing the adjusted basis of the property, the realized gain from the
foreclosure or short sale would be increased (or the loss reduced). The amount
of CODI excluded and the section 1250 recapture amount would cancel one
another. Thus, the immediate recapture will negate any tax benefit from the
CODI exclusion under IRC § 108(a)(1)(D).
C.1. Recapture Reductions
(1) IRC § 1245 property is defined as any property which is or has been property of
a character subject to the allowance for depreciation provided in IRC § 167 and
is either personal property, other property, real property, single purpose
agricultural or horticultural structure, storage facility, or any railroad grading or
tunnel bore. Refer to IRC § 1245 for more details.
(2) IRC § 1250 property is defined as any real property other than IRC § 1245
property which is or has been property subject to the allowance for depreciation
provided in IRC § 167, for example, rental real estate property.
(3) Property that is neither IRC § 1245 or IRC § 1250 property is treated as IRC §
1245 property (IRC § 1017(d)(1)(A)).
(4) Any basis reduction as a result of excluding CODI from gross income is treated
as depreciation for IRC § 1245 and IRC § 1250 property (IRC § 1017(d)(1)(B)).
56
(5) Depreciation taken in excess of straight-line depreciation is recaptured. Under a
special rule for IRC § 1250 property, when determining whether there is excess
depreciation for IRC § 1250 depreciation recapture, basis reductions under IRC
§ 1017 are ignored (IRC § 1017(d)(2)).
C.2. Examples
(1) Example 24. Michael owns depreciable real estate property used for his retail
business. His adjusted basis in the property is $200,000 (includes bases
reductions) before the discharge of debt. The outstanding recourse loan
balance is $180,000. Michael had no other debt secured by this depreciable
real property. The retail business incurred a net operating loss of $18,000 in
year 1.
(2) During year 1, Michael lost major customers due to the economy’s downturn
and he was unable to make the monthly mortgage payments and had to close
the store. This was Michael’s only business and means of earning a living. The
lender foreclosed on the property in year 1 and sold it for $150,000. The lender
issued Michael a Form 1099-C for canceled debt of $30,000.
(3) Immediately before the cancellation, Michael was insolvent to the extent of
$13,000. He can exclude $13,000 of the canceled debt from income under the
insolvency exclusion. Because of that exclusion, he reduced his NOL by
$13,000.
(4) Michael can elect to exclude the remaining $17,000 (30,000 minus 13,000) of
canceled debt from income under the qualified real property business
indebtedness provision. The amount he can exclude is subject to both of the
following limitations.
(5) The first step is to determine the debt in excess of value. The maximum amount
of CODI that can be excluded from gross income is $30,000 ($180,000
outstanding principal loan amount immediately before discharge minus
$150,000 fair market value of property minus zero, the outstanding principal
amount of any other qualified real property business debt secured by the
property immediately before discharge.
(6) The overall limitation equals $200,000. The excluded debt shall not exceed the
aggregate adjusted bases of depreciable real property held immediately before
the discharge, (excluding depreciable real property acquired in contemplation of
the discharge) reduced by the sum of certain bases reductions.
(7) In this example, the aggregate adjusted bases of depreciable real property held
before the discharge is $200,000 (includes bases reductions). Since both
limitation amounts ($30,000 and $200,000) are more than the remaining
$17,000 of canceled debt, Michael can also exclude the $17,000 from income.
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Michael’s tax attribute balances are the NOL carryover to year 2 of $5,000
($18,000 minus $ 13,000 insolvency exclusion) and the adjusted basis of the
retail business property of $183,000 ($200,000 adjusted basis immediately
before the disposition minus $17,000 IRC §1017(b)(3)(F) qualified real property
business exclusion).
(8) Michael checks the boxes on lines 1b and 1d of Form 982 and enters $30,000
on line 2. He completes Part II of Form 982 to reduce his basis of depreciable
real property by entering $17,000 on line 4 and entering $13,000 for the NOL
from year 1 on line 6. None of the $30,000 canceled debt is included in his
income. The disposition of the business retail store building is reported on Form
4797 as shown in the following table.
(9) Form 4797
Description
Amount
FMV of the property
150,000
Add any proceeds received from the foreclosure
0
Minus adjusted basis of the property reduced before the
disposition IRC § 1017(b)(3)(F)(iii)
183,000
Equals the loss from the foreclosure
33,000
(10) Example 25 (Part II with facts modified from Example 11). Peter bought a
grocery store in year 1 that he operated as his sole proprietorship. Peter made
a $25,000 down payment and financed the remaining $250,000 of the purchase
price with a recourse bank loan. Peter had no other debt secured by that
depreciable real property, but he owned depreciable equipment and furniture
with an adjusted basis of $76,000. Peter’s tax attributes included the basis of
depreciable property, a net operating loss, and a capital loss.
(11) In year 7, Peter was approved for a loan modification with the lender and
$25,000 of the outstanding balance of the debt was canceled. Peter qualifies to
exclude CODI under IRC § 108.
(12) Other facts, immediately before the cancellation of debt include the following:
• Peter was not bankrupt, but he was insolvent to the extent of $15,000.
• Outstanding principal balance on the grocery store loan was $195,000.
• FMV of the store was $170,000.
• Adjusted basis of the store was $225,926
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• The bank sent Peter a Form 1099-C for year 7 showing canceled debt of
$25,000.
(13) Peter must apply the insolvency exclusion before applying the qualified real
property business indebtedness exclusion. Peter can exclude $15,000 of the
canceled debt from income under the insolvency exclusion. Peter elects to
reduce his basis of depreciable property before reducing other tax attributes.
The attribute reductions follow.
(14) On January 1 of year 8, the bases reduction shall not exceed the aggregate
adjusted bases of the depreciable property held by the taxpayer as of the
beginning of the taxable year following the taxable year in which the discharge
occurs. Peter was insolvent by $15,000 which is less than the basis limitation of
$301,926 ($225,926 store plus $61,000 equipment plus $15,000 furniture).
(15) Under the election to reduce depreciable property first in IRC § 108(b)(5) and
Treas. Reg. § 1.1017-1(c), property that secured that discharged debt is
reduced first. After the basis reduction, Peter’s adjusted basis in the store
property is $210,926 ($225,926 adjusted basis of store minus $15,000 insolvent
amount).
(16) Peter now looks to the limitations under the qualified real property business
indebtedness exclusion for the remaining CODI of $10,000 (25,000 less 15,000)
as follows:
(17) The first step is to determine the debt in excess of value. The maximum CODI
amount that can be excluded from gross income equals $25,000 ($195,000
grocery store’s outstanding principal loan amount, immediately before
discharge minus $170,000 fair market value of property less $0 the outstanding
principal amount of any other qualified real property business debt secured by
the property).
(18) The second step is to determine the overall limitation. The excluded debt shall
not exceed the aggregate adjusted bases of all depreciable real property held
before the discharge, (excluding depreciable real property acquired in
contemplation of the discharge) reduced by the sum of certain basis reductions.
The overall limitation is $210,926 ($225,926 aggregate adjusted bases (already
reduced by depreciation)) of depreciable real property held before the discharge
minus $15,000 basis reduction made under the insolvency exclusion (IRC §
108(b) plus zero basis reduction made under the qualified farm exclusion (IRC
§ 108(g)).
(19) Peter’s exclusion is also limited to the overall limitation of $210,926, the total
adjusted basis (determined after reduction for the canceled debt excluded
under the insolvency exclusion) of his depreciable real property, he held
immediately before the cancellation of debt.
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(20) Since both of these limits exceed the $10,000 of the remaining canceled debt
($25,000 minus $15,000), Peter can exclude $10,000, under the qualified real
property business indebtedness exclusion.
(21) In summary, Peter can exclude the entire $25,000 of canceled debt, $15,000
under the insolvency exclusion and $10,000 under the qualified real property
business indebtedness exclusion.
(22) Peter would complete Form 982 with a check mark on lines 1b and 1d
(insolvency & qualified real property business indebtedness exclusions,
respectively), $25,000 on line 2 (total excluded from gross income), $10,000 on
line 4 (amount of qualified real property business basis reduction) and $15,000
on line 5 (election to reduce basis first).
D. Qualified Principal Residence Indebtedness - Attribute Reduction
(1) IRC Section § 108(h)(1) provides that the amount of qualified principal
residence indebtedness excluded will be applied to reduce (but not below zero)
the basis of the taxpayer's principal residence. Furthermore, IRC § 108(h)(1)
only requires that the basis of the home be reduced under the qualified principal
residence exclusion in the year that debt is discharged. Thus, if the taxpayer
enters into a loan modification, the basis of the home is reduced in the same
year that debt is forgiven. When the taxpayer ultimately sells the residence, the
lowered adjusted basis will be used to compute the gain or loss.
(2) Alternatively, if the home is foreclosed, the taxpayer is not required to reduce
the basis of the home, because it is no longer owned and no other tax attributes
(e.g., NOL, general business credit, etc.) are reduced. In this situation, any debt
forgiven is generally after the repossession and sale of the property.
D.1. Examples
(1) Example 26. Walter and his spouse received a loan modification for their
principal residence and the bank discharged $52,435 of the debt. The entire
nonrecourse debt balance before and after the discharge is qualified principal
residence indebtedness. IRC § 108(h)(1) states that the basis in the principal
residence is reduced by the same amount of debt that is discharged. The
taxpayers exclude the entire $52,435 from income and files Form 982 with their
tax return. They check line 1e, enter $52,435 on line 2, and enter $52,435 on
line 10b (reduce the basis of the principal residence). Three years later the
taxpayers sell their home for $600,000. They purchased the home for $580,250.
The adjusted basis is $527,815 ($580,250 minus $52,435). The gain on the
sale is $72,185 ($600,000 minus $527,815) reported on Schedule D, but is
excluded from gross income under IRC § 121.
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(2) Example 27. Aaron’s principal residence was foreclosed and the lender forgave
$100,000 of the debt after the foreclosure sale. The entire recourse loan was
qualified principal residence indebtedness. Aaron excludes the entire $100,000
from income and files Form 982 along with the return, checks line 1e, and
enters $100,000 on line 2. Aaron does not enter any amount on line 10b
(reduce basis of principle residence) because the residence is no longer owned.
Furthermore, the taxpayer is not required to reduce the basis in any other
assets owned.
(3) Example 28. Betty and her spouse purchased a principal residence for
$625,000 through a primary nonrecourse mortgage loan of $525,000 and a
subordinate recourse loan for $100,000. Several years later they faced financial
difficulties and ultimately entered into a short sale agreement with the lenders.
On August 20 in year 7, the subordinate lender forgave $100,000. The house
eventually sold for $500,000 on April 15 in year 8.
(4) The taxpayers reported the canceled debt amount in year 7 on Form 982 with a
check mark on line 1e, discharge of qualified principal residence indebtedness,
$100,000 on line 2, amount of discharged debt excluded from gross income and
$100,000 on line 10b, reduce basis in principal residence.
(5) The adjusted basis of the principal residence on August 21 in year 7 was
$525,000 ($625,000 cost minus $100,000 basis reduction). The gain or loss on
the short sale of the principal residence reported on the Schedule D for year 8
was zero ($525,000 outstanding nonrecourse loan balance minus $525,000
adjusted basis).
(6) Example 29. Barton and his spouse purchased their principal residence in year
1 and received a loan modification in year 10. The loan qualifies as principal
residence indebtedness in IRC § 108(h)(2). The lender forgave $90,000 of the
principal recourse loan balance of $378,569. The taxpayers plan to convert the
property to a rental in year 11 and do not want to reduce the basis of the
principal residence by the entire $90,000. Therefore, they elect to apply the
insolvency exclusion in lieu of the principal residence exclusion under IRC
§108(a)(2)(C). They are insolvent by $50,790 ($900,000 liabilities immediately
before the discharge of debt minus $849,210 FMV of assets immediately before
the discharge of debt). The only tax attribute was a NOL from year 10 of
$60,000.
(7) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount of tax attributes
reduced under IRC § 108(b).
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(8) Tax Attribute Reduction Calculation on January 1 of Year 11
Description Tax Attribute CODI
CODI excluded from
gross income
50,790
Minus NOL (Year 10) 50,790
CODI balance 0
(9) The taxpayers are allowed to exclude $50,790 from gross income to the extent
of insolvency. However, they are required to include $39,210 ($90,000 debt
forgiven minus $50,790 extent of insolvency) in gross income. The taxpayers
are not required to reduce the basis in the principal residence by electing the
insolvency exclusion in lieu of the qualified principal residence exclusion. Only
the NOL carryover from year 10 is reduced to $9,210 ($60,000 NOL minus
$50,790 tax attribute reduction).
V. Rental Real Estate Property
A. Overview
(1) In addition to the rules discussed earlier, if the property is rental real estate
property, current and suspended passive losses should be considered. Losses
are not allowed unless the disposition is a qualifying disposition under IRC §
469(g)(1)(A).
B. Qualifying Dispositions Under IRC § 469(g)
(1) A taxpayer must dispose of his entire interest in the activity in order to trigger
the recognition of loss. If he disposes of less than his entire interest, then the
issue of ultimate economic gain or loss on his investment in the activity remains
unresolved. A disposition of the taxpayer’s entire interest involves a disposition
of the taxpayer’s interest in all entities that are engaged in the activity, and to
the extent held in proprietorship form, of all assets used or created in the
activity. If the taxpayer has adequate records of the suspended losses that are
allocable to that activity, and includes in income the gain (if any) allocable to his
entire interest in the activity, such losses are allowed in full upon the disposition.
IRS CCA 201415002; 2014 IRS CCA LEXIS 29.
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(2) If the taxpayer has a qualifying disposition under IRC § 469(g), the current and
suspended passive losses on the activity are allowed in full assuming the
taxpayer has basis and at-risk. The three tests under IRC § 469(g) that must be
met as a qualifying disposition are:
• 1. Disposition must be made to an unrelated party (IRC § 267) and
• 2. The disposition must be fully taxable. All gain/loss must be realized and
recognized (a foreclosure is considered a fully taxable disposition) and
• 3. The property must be disposed of entirely or substantially (Treas. Reg.
§ 1.469-4).
(3) Cancellation of debt income is added to gross rents received on Form 1040
Schedule E, when the debt is related to non-business, non-farm rental of real
property. The cancellation of debt income is reported on Form 4835 for certain
farming rental activities.
(4) Chief Counsel Advice Memorandum IRS CCA 201415002; 2014 IRS CCA
LEXIS 29 provides detailed guidance on the interaction of sections 108 and
469(g) of the Internal Revenue Code. The memorandum addresses whether a
foreclosure on real property subject to recourse debt comprising a taxpayer’s
entire interest in a passive (or former passive) activity qualifies as a fully taxable
disposition for purposes of IRC § 469(g)(1)(A), where the foreclosure triggers
cancellation of indebtedness (COD) income that is excluded from gross income
under IRC § 108(a)(1)(B).
(5) Chief Counsel concluded that a foreclosure on real property subject to recourse
debt comprising the taxpayer’s entire interest in a passive (or former passive)
activity is a fully taxable transaction for purposes of IRC §§ 1001 and
469(g)(1)(A), regardless of whether any CODI from the cancellation of recourse
debt is excluded under IRC § 108(a)(1)(B). Thus, the losses from the activity
are treated as not from a passive activity under IRC § 469(g)(1)(A). Additionally,
these losses are not reduced by any excluded CODI under IRC § 108(b)(2)(F).
(6) Multiple examples are provided in this CCA to illustrate the interaction of
sections 108 and 469(g) of the Internal Revenue Code. For example, Taxpayer
A has disposed of the property in a fully taxable transaction under IRC § 1001
and realizes and recognizes $25,000 of gain on the foreclosure. Thus, the
transaction is a fully taxable transaction for purposes of IRC § 469(g)(1)(A), and
the $100,000 of suspended passive losses are treated as losses not from a
passive activity under IRC § 469(g)(1)(A). Additionally, Taxpayer A may exclude
the $75,000 CODI from the cancellation of the recourse mortgage under IRC §
108(a)(1)(B) because A is insolvent to the extent of $200,000.
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(7) Taxpayer A does not reduce the $100,000 of non-passive losses by the
$75,000 CODI excludable under IRC § 108(a)(1)(B). Under IRC § 108(b)(2)(F)
any CODI from the taxable year of the discharge reduces any passive activity
loss and credit carryover of the taxpayer under IRC § 469(b) from the year of
the discharge. However, under IRC § 108(b)(4), reductions to tax attributes
required by IRC § 108(b) are made after determination of tax for the year of
discharge.
(8) In this case, in determining Taxpayer A’s tax for the year of the discharge, all
previously suspended losses under IRC § 469(b) are freed-up and fully
allowable upon the taxable foreclosure. Therefore, there are no remaining IRC
§ 469(b) suspended loss carryovers that are reduced under section IRC §
108(b)(2)(F).
(9) Revenue Ruling 92-92, 1992-2 C.B. 103 states that, “For purposes of section
469 of the Code, COD income is characterized as income from a passive
activity to the extent that, at the time the indebtedness is discharged, the debt is
allocated to passive activity expenditures”. Any amount of the debt that was not
used for passive activities is allocated to nonpassive activities.
C. Disqualifying Dispositions Under IRC § 469(g)
(1) When a disposition is non-qualified, the current and suspended passive losses
on the activity remain on Form 8582 until passive income is reported.
(2) The following do not qualify as fully taxable dispositions (not an exhaustive list):
• Abandonment (qualifying disposition if abandonment rules are met in IRC
§ 165)
• Bankruptcy which has not been finalized; IRC § 1398(f)(1), Treas. Regs.
§§ 1.1398-1(c) and (d)(1)
• Related party transfers
• Rental property converted to personal use
• Transfer due to divorce (treated as gift; IRC § 469(j)(6) & § 1041(b))
• Foreclosure of a property with recourse debt where the foreclosure sale
has not occurred. This is not a qualifying disposition under IRC § 469(g)
and any losses (disposition or suspended operational) are not currently
deductible.
• Loss on foreclosure of a rental property where the taxpayer has
aggregated rentals. Disposition of one rental is not “complete” under IRC §
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469(g). In years that a taxpayer is NOT a real estate professional, the
election under Treas. Reg. § 1.469-9(g) is not binding.
D. Depreciation Recapture
(1) There is no depreciation recapture for IRC § 1250 property for which ACRS or
MACRS depreciation deductions are computed using the straight-line method.
Depreciation must be recaptured if straight-line method was not used. The
recapture amount is treated as ordinary income.
(2) Depreciation recapture for IRC § 1250 property generally is the lesser of the
additional depreciation or the excess of the amount realized (in the case of a
sale, exchange, or involuntary conversion) or the fair market value of such
property (in the case of any other disposition), over the adjusted basis of such
property.
(3) Additional depreciation is the depreciation claimed or for property held more
than one year, the excess of the depreciation actually claimed over the amount
that would have been claimed had the straight-line method been used.
(4) The basis reduction special rule for depreciation is determined before any basis
reduction. Basis reductions, when CODI is excluded from income, are treated
as depreciation for purposes of the depreciation recapture provisions, IRC §
1017(d)(1)(B), even if the property otherwise would not be subject to those
provisions, IRC § 1017(d)(1)(A).
E. Character of Property at Disposition
(1) IRC § 1221 provides in part that the term capital asset means property held by
the taxpayer (whether or not connected with his trade or business) but does not
include property, used in a trade or business, of a character which is subject to
the allowance of depreciation provided in IRC § 167.
(2) IRC § 1231(b)(1) provides in part that the term “property used in a trade or
business” means property used in a trade or business, of a character which is
subject to the allowance of depreciation provided under IRC § 167, held for
more than 1 year.
(3) The disposition of investment property, second home, vacation home, and
personal residence are all reported on Schedule D. The disposition of rental
real estate property that is not a trade or business is also reported on
Schedule D. The disposition of rental real estate property that is a trade or
business is reported on Form 4797.
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F. Lease with Option to Buy
(1) If a rental agreement gives the tenant the right to buy the rental property, the
payments received by the lessor under the agreement are generally rental
income. If the tenant exercises the right to buy the property, the payments the
lessor receives for the period after the date of sale are considered part of the
selling price.
G. Examples
(1) Example 30. Martha operated a Schedule C business as a divorce attorney
and she is not a real estate professional. In year 1, she took out a recourse loan
for $800,000 and purchased an apartment building as an investment. A
property management company managed the property. During year 4 through
year 6, some of the tenants moved out and others were evicted when they
stopped paying rent. In year 5, Martha applied for a loan modification that was
declined due to the low rents. In year 6, she depleted her savings and was
unable to pay the mortgage, therefore, the lender foreclosed on the property in
year 8. The property was sold in year 8 for $460,050 and Martha was issued a
Form 1099-C with a forgiveness of debt of $189,950.
(2) Immediately before the foreclosure, the recourse loan balance was $650,000,
the FMV of the apartment building was $460,050, adjusted basis was $704,545,
and suspended passive losses were $65,364.
(3) Martha’s cancellation of debt income for year 8 is $189,950 ($650,000
outstanding loan balance minus $460,050 FMV). Martha’s rental real estate
income reported on Schedule E for year 8 is $74,586 ($50,000 gross rents plus
189,950 other rental income, CODI, minus $100,000 rental expenses minus
$65,364 prior years’ passive losses).
(4) Martha’s realized loss from the foreclosure sale of the apartment building in
year 8 was $244,495 ($460,050 amount realized (FMV) minus $704,545
adjusted basis add zero depreciation recapture in excess of straight-line).
(5) Martha would report $189,950 of CODI on Schedule E in year 8 as additional
rent and she would report the disposition loss of $244,495 on Schedule D. The
capital loss deduction would be limited.
(6) Example 31. Charlie owned and rented a single-family residence that he used
in his business as a real estate professional. He did not make the election
under Treas. Reg. § 1.469-9(g) to group his rental properties. He purchased the
residence in year 1 for $480,000. Later, he refinanced the recourse loan and
received $30,000 that was used to make improvements on the property. In year
12, the outstanding loan balance was $470,000 and Charlie faced difficult
health and financial challenges and returned the property to the lender through
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an approved deed in lieu of foreclosure agreement. Although, a Form 1099- C
was not issued, the lender forgave $20,000 in year 12 according to the
agreement. The home was sold in year 13. Charlie was insolvent by $65,000.
(7) At the time of the deed in lieu of foreclosure agreement, the fair market value
was $450,000, adjusted basis was $425,000 and suspended passive losses
were $35,364. Although, a Form 1099-C was not issued, Frazier v.
Commissioner 111 T.C. 243, 246 (1998), will be relied upon and $20,000 is
income from the discharge of indebtedness per IRC § 61(a)(11).
(8) However, the entire $20,000 of cancellation of debt income is excluded from
income under the insolvency exclusion. The insolvency exclusion takes
precedence over the qualified real property business exclusion.
(9) Charlie’s recognized ordinary gain for the deed in lieu of foreclosure disposition
reported on Form 4797 is $25,000 ($450,000 FMV minus $425,000 adjusted
basis add zero depreciation recapture in excess of straight line). Although, the
loan is recourse, the outstanding loan balance was resolved through the deed
in lieu of foreclosure agreement. The outstanding recourse loan was resolved
despite any future sale of the property.
(10) Passive losses are released upon the disposition of the property in year 12, the
year that the deed in lieu of foreclosure agreement is made and the resolution
of the outstanding recourse loan balance is made. Charlie’s passive losses from
this rental are $45,795.
(11) The disposition of the property is a qualifying disposition under IRC § 469(g).
The disposition is reported on Form 4797 in Part III. Charlie is also allowed to
exclude $20,000 CODI under IRC § 108(a)(1)(B) and deduct all passive losses
of $45,795 incurred from the property.
(12) Charlie is required to reduce tax attributes owned on January 1 of year 13 by
$20,000, in the order identified in IRC § 108(b) under the insolvency exclusion.
By excluding CODI, Charlie has essentially deferred any tax associated with the
excluded CODI amount by reducing any tax attributes. Under IRC §
108(b)(4)(A) attributes are reduced after taxable income is determined. Tax
attributes owned on January 1 of year 13 are an NOL carryover from year 12 of
$5,000, an NOL carryover from year 11 of $3,000, and a capital loss carryover
from year 12 of $12,000. The tax attribute reductions are shown in the following
table.
(13) Note: The following presentation of tax attribute reduction is not meant to imply
that CODI is reduced, but only used to demonstrate the amount of tax attributes
reduced. Under IRC § 108(b)(1) the amount excluded from gross income shall
be applied to reduce tax attributes.
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(14) Tax Attribute Reduction on January 1 of Year 13
Description
Tax Attribute
CODI
CODI
$20,000
Minus NOL carryover
(Year 12)
F. 982 line 6 (Year 12)
5,000
CODI Balance
15,000
Minus NOL carry over
(Year 11)
F. 982 line 6 (Year 12)
3,000
CODI Balance
12,000
Minus Capital loss
carryover (Year 12)
F. 982 line 9 (Year 12)
12,000
CODI Balance
0
(15) In summary, CODI excluded from rental income for year 12 under the
insolvency exclusion is $20,000 and the January 2 tax attribute balances for
year 13 are zero ($5,000 NOL (year 12) minus $5,000 NOL tax attribute
reduction), zero NOL from year 11 ($3,000 NOL (year 11) minus $3,000 tax
attribute reduction), and zero capital loss carryover from year 12 ($12,000
capital loss carryover minus $12,000 tax attribute reduction).
(16) Because the facts and circumstances of each taxpayer may be unique, the
passive rules could be applied slightly differently in every examination. Refer to
the Passive Activity Loss Audit Technique Guide for a complete discussion on
passive activity loss activities or contact a Passive Activity Loss Technical
Advisor.
H. Audit Strategies
(1) When CODI, Form 4797 gain/loss or Schedule D gain/loss, and Schedule E
gain/loss for all years are netted, you arrive at an overall gain or loss. If this is a
loss, ask yourself whether the taxpayer is “poorer” by that amount. If the
taxpayer could not afford to sustain that loss then how were the losses funded
(e.g., other debt, current year income, other assets)?
(2) Sometimes taxpayers attempt to convert their principal residence into rental real
estate property right before it forecloses and deduct losses. A temporary
conversion may not be a true rental activity and loss from the foreclosure would
be a non-deductible personal loss. In addition, expenses (e.g., property
insurance) would generally be non-deductible personal expenses. It is important
to ascertain the facts and circumstances surrounding the reasons for converting
the residence to a rental to determine if it was a principal residence, second
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home or rental property. In MaDan v. Commissioner, (T.C. Memo. 1986-7), the
petitioners listed their vacant home with three different realtors as “For Sale or
Rent.”. The court ruled, “even if exclusively for rent would not be sufficient to
establish a profit motive”. Whereas, in Sherlock v. Commissioner, (T.C. Memo.
1972-97), the court held that a bona fide intention to rent the vacant residence
was converted for the production of income even though, it was never rented.
One factor the court relied upon was the taxpayer’s willingness to accept low
rent.
(3) What efforts did the taxpayer make to rent the property? Has the taxpayer
provided any documentation of the time spent attempting to the rent the
property? Has the taxpayer provided copies of advertisements, listing
agreements or other evidence that the property was in fact held out for rent?
(4) Insurance policies should reflect if the property is a rental, personal residence,
vacant investment, etc.
(5) If applicable, how was the property taxed? For real estate property taxes, what
is the taxpayer telling the local assessor as to the use of the property? Rental?
Vacant? Personal?
(6) Non-issuance of a Form 1099-C does not relieve a taxpayer of their
responsibility to include CODI in income. Identify all loans on the property
through internal records and/or property records. All loans should be considered
in the CODI and gain/loss calculations. Review internal records from one or two
years prior to the foreclosure to identify other debt associated with the
foreclosed property. The taxpayer may not have a Form 1098 issued for interest
paid in the year of foreclosure, because they made no payments.
(7) Consider state foreclosure laws of where the property is located. State laws
govern foreclosure actions by the lender which will determine the date of sale.
VI. Abandonments
A. Tax Consequences of Abandonments
(1) Abandonment is treated as an exchange of property when the owner gives up
possession and use of the property voluntarily and permanently to the lender,
with the intention of ending his/her ownership and does not pass it on to anyone
else. Abandonment may lead to foreclosure proceedings in order for the lender
to obtain legal possession of the property. Abandonment is different from a
voluntary conveyance such as a deed in lieu of foreclosure. Generally, the
lender and the homeowner enter into a deed in lieu of foreclosure agreement
where the transaction is treated as an exchange of property to satisfy a debt.
(2) Whether abandonment has occurred or not is determined by a review of all the
facts and circumstances. Intent to abandon the property by affirmative acts
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should be considered to determine whether abandonment occurred. For
example, permanently moving out and mailing the keys to the lender can be
indicators of the intent to abandon the property. A lender is required to issue a
Form 1099-A when the lender determines that property has been abandoned.
(3) The tax consequences depend on whether the debt is recourse or nonrecourse.
If the amount realized is more than the adjusted basis, then a gain is realized. If
the adjusted basis is more than the amount realized, then a loss is realized. The
character of the loss depends on the character of the property. For example, no
loss is allowed for abandonment of a personal residence, but a loss from an
abandoned business property, rental property, or investment property may be
allowed.
(4) If the debt is nonrecourse, a sale or exchange is reported in the year the
property is abandoned. If the debt is recourse, then the gain/loss is not reported
until the year that foreclosure sale is completed. The IRS has seen that the
Form 1099-A may be issued several months or years after the taxpayer has
actually abandoned the property. The disposition is not reported until the lender
takes action on the property and possibly against the taxpayer within state law
timeframes.
(5) The court in George v. United States, 1996 WL 437532 (D. Colo. 1996), stated,
“[T]he worthlessness and abandonment arguments, however, are inapplicable
to recourse debts as a matter of law. Property that secures a taxpayer's
recourse obligation is not worthless prior to foreclosure. Commissioner v.
Green, 126 F. 2d 70, 72 (3d Cir. 1942) (“where, as here, the taxpayer is liable
for the debt, interest and taxes by virtue of the mortgage or the bond thereby
secured, the property continues until foreclosure sale to have some value
which, when determined by the sale, bears directly upon the extent of the
owner's liability for a deficiency judgment.”) Likewise, property that secures a
taxpayer's recourse obligation may not be considered abandoned for purposes
of a loss deduction prior to foreclosure. Daily v. Commissioner, 81 T.C. 161
(1983) (an attempt to abandon property subject to recourse debt does not
result in a deductible loss), aff'd, Daily v. C.I.R., 742 F.2d 1461 (9th Cir. 1984);
Middleton v. Commissioner, 77 T.C. 310, 323 (1981) (“at least one court has
held that the abandonment of property subject to a recourse debt does not
result in loss until the foreclosure sale because, since the possibility of
deficiency exists, the amount of the loss cannot be fixed until the sale takes
place.”), aff'd, Middleton v. Commissioner, 693 F.2d 124 (11th Cir. 1982).”
(6) Completion of a foreclosure is determined by state law. When the year of
disposition is in question, examiners should seek advice from their local counsel
to determine when a foreclosure is complete.
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B. Examples
(1) Example 32. In year 1, Diana purchased her principal residence for $200,000.
She borrowed the entire purchase price through a recourse loan. In year 5,
Diana’s employer faced financial difficulties and reduced employees’ salaries
which caused a financial hardship on Diana and she was unable to meet her
financial obligations. The loan balance on her home was $185,000 and the FMV
declined from $250,000 to $150,000. Diana decided to abandon her home,
moved her belongings out, and mailed the keys and garage door opener to the
lender on August 1 of year 5. The bank eventually foreclosed and sold the
home in year 6 and issued a Form 1099-C.
(2) Because Diana is personally liable for the debt, she does not report a gain or
loss, or CODI in year 5 when she abandoned the home, but in year 6 when the
disposition was completed. The affirmative acts taken by Diana by permanently
moving out and mailing the keys to the lender indicate her intent to abandon the
home, but the lender did not recognize the abandonment until year 6 when the
lender foreclosed on the property.
(3) Example 33. In year 1, Ruby purchased a second home for $315,000. She
borrowed the entire purchase price through a nonrecourse loan. In year 7, the
value of her property declined to $289,000 and she was able to obtain a loan
modification. The lender forgave $26,000, the difference between the
outstanding loan amount and the current FMV of the property. In year 8, Ruby
was unable to make the monthly payments and abandoned the property. The
lender did not become aware that the property was vacant until year 9 and
issued a Form 1099-A. The lender eventually sold the property in a foreclosure
sale in year 10.
(4) Ruby does not meet any of the exclusions in IRC §108(a)(1). Therefore, she
reported the entire $26,000 discharged debt as other income on Form 1040 for
year 7. Because Ruby was not personally liable for the note, she would report
the disposition in year 9, when the lender released her from legal responsibility
of the property and note.
(5) As indicated in the examples above, the dispositions were reported in different
years. In Example 32, the loan was recourse and the taxpayer was not required
to report the disposition until the year that the foreclosure sale was complete.
The sale determined the deficiency amount. In some cases, a lender may
choose to forgive a portion or the entire amount of the deficiency. Depending on
state law and the manner of foreclosure action taken, the taxpayer possibly
would be responsible to pay back a portion or the entire deficiency balance
once the lender obtains a deficiency judgment.
(6) Since the loan was nonrecourse in Example 33, the disposition is reported in
the year that the lender acknowledges that an abandonment occurred through
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the issuance of a Form 1099-A. Repossession of the property by the lender
satisfied the debt.
VII. Form 1099-A and Form 1099-C
A. Background
(1) A lender must follow the reporting regulations that determine when a Form
1099-A and/or Form 1099-C are issued to the borrower. Treas. Reg. §
1.6050P–1 governs the information reporting for discharges of indebtedness by
certain entities. The instructions to Form 1099-A and Form 1099-C provide an
overview of these rules.
(2) A debt is deemed to be discharged for information reporting purposes only upon
the occurrence of an identifiable event specified under Treas. Reg. § 1.6050P–
1(b)(2), whether or not an actual discharge has occurred on or before the date
of the identifiable event. See Treas. Reg. § 1.6050P–1(a)(1).
(3) An identifiable event under Treas. Reg. § 1.6050P–1(b)(2)(i)(H) has occurred
during a calendar year if a creditor has not received a payment on an
indebtedness at any time during a testing period (as defined in Treas. Reg. §
1.6050P–1(b)(2)(iv)) ending at the close of the year. The testing period is a 36–
month period increased by the number of calendar months during all or part of
which the creditor was precluded from engaging in collection activity by a stay
in bankruptcy or similar bar under state or local law. The presumption that an
identifiable event has occurred may be rebutted by the creditor if the creditor (or
a third-party collection agency on behalf of the creditor) has engaged in
significant, bona fide collection activity at any time during the 12–month period
ending at the close of the calendar year, or if facts and circumstances existing
as of January 31 of the calendar year following expiration of the 36–month
period indicate that the indebtedness has not been discharged. Treas. Reg. §
1.6050P– 1(b)(2)(iv) further states that, significant, bona fide collection activity
does not include automated mailings, but does include a lien against the debtor.
Under Treas. Reg. § 1.6050P-1(b)(2)(i), identifiable events, in general, are
summarized below:
• A. A discharge of indebtedness under bankruptcy;
• B. A cancellation or extinguishment of an indebtedness that renders a
debt unenforceable in a receivership, foreclosure, or similar proceeding in
a federal or State court;
• C. A cancellation or extinguishment of a debt upon the expiration of the
statute of limitations for collection of a debt;
• D. A cancellation or extinguishment of an indebtedness pursuant to an
election of foreclosure remedies by a creditor that statutorily extinguishes
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or bars the creditors right to pursue collection of the indebtedness (e.g.,
non-judicial foreclosures in some states);
• E. A cancellation or extinguishment of an indebtedness that renders a
debt unenforceable pursuant to a probate or similar proceeding;
• F. A discharge of debt pursuant to an agreement between an applicable
entity and a debtor, to discharge indebtedness at less than full
consideration (e.g., short sale);
• G. A discharge of debt pursuant to a decision by the creditor, or the
application of a defined policy of the creditor, to discontinue collection
activity and discharge debt; or
• H. In the case of an entity described above in (A) through (C), the
expiration of the non- payment testing period.
(4) The first seven identifiable events are specific occurrences that typically result
from an actual discharge of indebtedness. The eighth identifiable event, the
expiration of a 36-month non-payment testing period, may not result from an
actual discharge of indebtedness. Due to debtors’ confusion regarding whether
the receipt of a Form 1099-C represented cancellation of debt income under the
36-month non-payment testing period, the Treasury Department and IRS issued
Notice 2012-65 (2012-52 IRC 773 (Dec. 27, 2012)), and requested comments
from the public. Several commentators recommended either the removal or
revision of the 36-month rule.
(5) The Treasury Department and IRS agree that the information reporting should
generally coincide with the actual discharge of a debt. The Department of the
Treasury and the IRS are concerned that the 36-month rule creates confusion
for taxpayers and does not increase tax compliance by debtors or provide the
IRS with valuable third-party information that may be used to ensure taxpayer
compliance. Consequently, in October 2014, the IRS issued proposed
regulations to remove the rule that a deemed discharge of indebtedness for
which a Form 1099 - C, Cancellation of Debt must be filed occurs at the
expiration of a 36 -month non-payment testing period. The proposed
regulations will affect certain financial institutions and governmental entities.
See 79 FR 61791-01, 2014 WL 5144724 (F.R.).
B. Example
(1) Example 34. Marion purchased property in year 1. The property was foreclosed
in year 10 and the lender issued a Form 1099-A. The lender did not sell the
property until year 14 and issued a Form 1099-C at that time. The year of the
disposition would depend on the 1) type of loan and 2) state law of where the
property is located.
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C. Examination Considerations
(1) Generally, the Service may rely on the Form 1099-A and Form 1099-C that are
issued to taxpayers. Nevertheless, as previously discussed, the issuance of a
Form 1099-C solely due to the 36-month testing period may create challenges
during the examination. Secondly, as discussed later, an examiner may
encounter inaccurate forms. Sometimes, a taxpayer is not issued a Form 1099-
A or C on subordinate loans or the taxpayer may not be issued a Form 1099-C
on either loan. This does not relieve the taxpayer from reporting the CODI.
(2) The determination of whether discharge of indebtedness has occurred is factual
and often the subjective intent of the creditor as manifested by an objectively
identifiable event (Kleber v. Commissioner, T.C. Memo. 2011-233 at *3). The
issuance of a Form 1099-C is an identifiable event, but it is not dispositive of an
intent to cancel indebtedness. For example, in Kleber v. Commissioner, supra,
although the creditor issued the Form 1099-C for the debtor-taxpayer’s 2006 tax
year, the court found that the discharge of the taxpayer’s indebtedness had
occurred during her 2002 tax year. Therefore, the Service can assert that a
taxpayer’s indebtedness has been discharged for the tax year it became clear
that a debt would never be repaid, even if the creditor did not issue a Form
1099-C for that year.
(3) The court decided in Rinehart v. Commissioner (T.C. Memo. 2002-71) that
although Ms. Yeager did not receive a Form 1099-C, the facts led the court to
believe that the debt was forgiven and this amount should have been included
in income. The court relied on Cozzi v Commissioner, 88 T.C. 435, 455 (1987)
and Vaughn v Commissioner, T.C. Memo. 1992 -317, affd. without published
opinion 15 F.3d 1095 (9th Cir. 1993) and stated,
“When it becomes clear that a debt will never have to be paid, such debt
must be viewed as having been discharged, creating income to debtor,
and receipt of Form 1099-C from the lender is not determinative…Non
receipt of a Form 1099 does not convert taxable income into nontaxable
income.”
(4) It is important to identify all loans on the property to determine the correct gain
or loss and CODI. A review of property information, county recorder documents,
Forms 1099 (e.g., including prior and subsequent years of examination),
Schedule A mortgage interest, and/or loan documents should be made.
(5) The following facts and circumstances should be considered to determine
whether the taxpayer has cancellation of debt income when a taxpayer is not
issued a Form 1099-C:
• Identification of whether the loan was recourse or nonrecourse.
• The sale was completed.
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• Lender was awarded a deficiency judgment.
• Collection activity taken against the taxpayer other than phone calls and
letters. Governing state law of where the property is located.
(6) When the real estate market crashed there were several news stories about
taxpayers who were not aware of the tax consequences of their foreclosed
property, especially if they did not receive a Form 1099-C. State foreclosure
laws govern foreclosure proceedings and actions that can be taken after a
foreclosure. For example, if a lender pursues a non-judicial foreclosure
proceeding, the lender will not be allowed to pursue a deficiency judgment in
some states.
(7) Therefore, if the taxpayer was not issued a Form 1099-C, it is important to
understand the governing state law where the property is located and the
actions taken by the lender to determine the CODI amount, if any. Facts and
circumstances will determine when the cancellation of debt should be reported.
Kleber v Commissioner, T.C. Memo. 2011-233, provides guidance on the
application of the rules in Treas. Reg. § 1.6050P-1.
(8) In light of IRC § 6050P, a question arises as to whether debt is discharged for
purposes of IRC § 61(a)(11), IRC § 61(a)(12) prior to January 1, 2019, and IRC
§ 108 when a borrower has not made a mortgage payment for at least 36
months. Whether a debt has been discharged is dependent on the substance of
the transactions (Cozzi v. Commissioner, 88 T.C. 435, 445 (1987)). The
moment it becomes clear that a debt will never be repaid, the debt must be
viewed as having been discharged. The test for determining such moment
requires a practical assessment of the facts and circumstances relating to the
likelihood of repayment. Any “identifiable event” which fixes the loss with
certainty may be taken into consideration (United States v. S.S. White Dental
Mfg. Co. of Pennsylvania, 274 U.S. 398 (1927)). The court stated that the mere
fact that a mortgagor has not made a payment for 36 months does not mean
that the debt has been discharged.
(9) IRC § 6050P and its regulations do not apply for determining whether the
debt has been discharged for purposes of IRC §§ 61(a)(11) and 108. The
limitation to eight identifiable events and the rebuttable presumption for a 36-
month non-payment period under Treas. Reg. § 1.6050P-1(b) apply only for
purposes of determining the creditor’s obligation to issue a Form 1099-C,
Cancellation of Debt. For purposes of IRC §§ 61(a)(11) and 108, the
determination whether debt has been discharged requires a practical
assessment of the facts and circumstances relating to the likelihood of
payment.
(10) If audit adjustments are made to include CODI, oral testimony from taxpayers
may not be enough factual development to support an adjustment, especially if
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the case is unagreed. In some states, the lender will publicize the foreclosure
notice and record the notice of default with the County Recorder’s office. The
case file should include documentation to support the Government’s position.
An explanation of each supporting document should be addressed to
strengthen the Government’s position. For example, a copy of the deed or
closing escrow documents will indicate dates, amounts, any monies given to the
seller (homeowner) which are needed for the calculation of the gain/loss.
(11) A Form 1099-A is issued when there is an identifiable event. For example, the
date when the lender becomes aware the property was abandoned or the date
of the foreclosure, short sale or deed in lieu of foreclosure. A Form 1099-C will
be issued when the property is sold, in a foreclosure sale, for example, and the
lender discharges some or all of the outstanding debt. A chart with the
identifiable codes is located in Publication 4681.
D. Inaccurate or Questionable Forms 1099-A and 1099-C
(1) Audit techniques are identified below when a Form 1099-A or Form 1099-C is
issued with questionable information. Common situations follow.
D.1. Form 1099-C Box 2. Amount of Debt Discharged
(1) Total debt includes total amount owed to the lender, including stated principal,
stated interest, fees, penalties, administrative costs, and fines. Prior to 2014,
the IRS instructions for Forms 1099-A and 1099-C instructed the filer not to
enter any amount the lender received in satisfaction of the debt by means of a
settlement agreement, foreclosure sale, etc.
(2) Since there is a possibility that this amount does not include any consideration
received, it may create a problem in identifying the actual amount of the
discharged debt for tax purposes. For example, a foreclosure sale resulted in
discharge recourse debt of $30,000. However, the lender entered $50,000 in
Box 2 which does not include consideration received from the foreclosure sale.
(3) Audit Technique - The loan documents or last mortgage statement or
settlement agreement letter (ie; short sale) and closing escrow documents
along with the Form 1099-A and/or Form 1099-C may help to determine the
loan balance and amount forgiven at the time of the disposition.
D.2. Form 1099-A Box 4 & Form 1099-C Box 7. Fair Market Value (FMV)
of Property
(1) Prior to 2014, the IRS instructions for box 7, FMV of Property, did not address
short sales and stated:
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“If you are filing a combined Form 1099-C and 1099-A for a foreclosure,
execution, or similar sale, enter the FMV of the property. Generally, the gross
foreclosure bid price is considered to be the FMV. If an abandonment or
voluntary conveyance to the lender in lieu of foreclosure occurred, enter the
appraised value of the property.”
(2) Audit Technique - A lender generally will conduct an appraisal prior to the
short sale of property and the FMV should be known. However, the IRS has
noted that some Forms 1099-C have been issued with a zero FMV amount.
Under these circumstances, the amount realized in a short sale is the sales
amount.
D.3. Form 1099-A & Form 1099-C Box 5. Check here if the Debtor was
Personally Liable for Repayment of the Debt
(1) The IRS instructions for Forms 1099-A and 1099-C provide, “If the debtor was
personally liable for repayment of the debt at the time the debt was created or, if
modified, at the time of the last modification, enter an “X” in the checkbox”.
(2) Box 5 does not specifically instruct the lender to identify whether the loan itself
was recourse or nonrecourse, but rather whether the borrower is liable to repay
the debt. If the lender has decided to forgive the outstanding debt, the borrower
is technically no longer liable. As such, the instruction may be interpreted as the
borrower is no longer liable for the outstanding debt through a short sale and,
therefore, the box is not checked.
(3) The loan documents will identify whether the debt was recourse or
nonrecourse. Some states may identify the original loan as nonrecourse and if
the loan is modified, it becomes recourse.
(4) Audit Techniques
• Obtain a copy of the loan documents to determine whether the loan was
recourse or nonrecourse. Look for language such as power of sale that
explains the actions that a lender may take if the borrower defaults on the
loan.
• If the taxpayer no longer has the records, summons the lender for a copy
of the loan documents.
• Seek assistance from local Counsel for specific state law questions.
D.4. Form 1099-C Box 6. Identifiable Event Code
(1) Box 6 may be left blank by a lender. The instructions are very self-explanatory,
“Enter the appropriate code to report the nature of the identifiable event…”
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However, a lender may conclude that a short sale does not qualify as an
identifiable event. Short sale should be included as an identifiable event F, “A
discharge of indebtedness under an agreement between the creditor and the
debtor to cancel the debt at less than full consideration.”
(2) Audit Technique - During the initial interview, ask the taxpayer or
representative the facts and circumstances regarding canceled debt. The type
of disposition will help to identify any additional documents to request.
VIII. Community and Common Law Property
A. Community and Common Law Property Systems
(1) Only an overview of community and common law property rules are presented
due to the complex issues that could arise. For complete procedural guidance
refer to IRM 25.18, Community Property, and Publication 555, Community
Property, for additional information on married taxpayers domiciled in common
law and community property states.
(2) Consideration of the ownership of foreclosed property may have different tax
consequences for taxpayers who own separate property from their spouses.
The state where the taxpayers live may have an impact on how a foreclosure is
reported. Federal tax is assessed and collected based upon a taxpayer’s
interest in property and state law. Thus, the effect on each spouse should be
addressed and case file documentation should include property considerations.
(3) Whether property is characterized as community property becomes less
important if a joint filing election is made. Spouses filing a federal joint return
are jointly and severally liable for the tax on all income of both spouses
reportable on the joint tax return, whether it is community property or separate
property.
(4) Forty-one states have adopted common law property systems. Common law
treats each spouse as a separate individual with separate legal and property
rights. Generally, each spouse owns and is taxed on the income that is
separately earned.
(5) Nine states have adopted the community property system. These states are
Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington
and Wisconsin. Alaska has also adopted a community property system, but it is
optional. The U.S. Territories of Guam and Puerto Rico are also community
property jurisdictions. Community property is where each spouse contributes
labor for the benefit of the family and shares equally in the profits and income
earned by the family. Thus, each spouse owns an automatic fifty percent
interest in all community property, regardless of which spouse acquired the
community property.
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B. Community Property
(1) Generally, community property is property that the taxpayer, taxpayer’s spouse
or both spouses together acquire during their marriage while the taxpayer and
taxpayer’s spouse are domiciled in a community property state, property agreed
upon to convert from separate to community property, and property that cannot
be identified as separate property. Refer to Publication 555, Table 1, General
Rules - Property and Income: Community or Separate?, for more information.
(2) Spouses are also considered to share debts. Each community property state
has its own specific property laws. Depending on state law, creditors of spouses
may be able to obtain all or part of the community property, regardless of how it
is titled, to satisfy debts incurred by either spouse. State laws vary greatly on
what property can be reached.
(3) In Aquilino v. United States, 363 U.S. 509 (1960) and Morgan v. Commissioner,
309 U.S. 78 (1940), the court decided that Federal law determines how property
is taxed, but state law determines whether, and to what extent, a taxpayer has
"property" or "rights to property" subject to taxation. Accordingly, federal tax is
assessed and collected based upon a taxpayer's state created rights and
interest in property.
(4) IRM 25.18.1.2.4, Tax Assessment and Collection under Community Property
Laws, states that, for income tax purposes, if spouses file separate returns,
each spouse is taxed on 50% of the total community property income
regardless of which spouse acquired the income. Poe v. Seaborn, 282 U.S. 101
(1930). In addition, each spouse is taxed upon 100% of his or her separate
property income. Community property may also affect basis in property.
(5) Refer to IRM Exhibit 25.18.1-1, Comparison of State Law Differences in
Community Property States, for a summary of the differences in the community
property laws adopted in the nine community property states.
(6) Generally, separate property is:
• Property that the taxpayer or taxpayer spouse owned separately before
their marriage.
• Money earned while domiciled in a non-community property state.
• Property that the taxpayer or spouse received separately as a gift or
inheritance during their marriage.
• Property that the taxpayer or spouse bought with separate funds, or
acquired in exchange for separate property, during their marriage.
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• Property that the taxpayer and spouse converted from community property
to separate property through an agreement valid under state law.
• The part of property bought with separate funds, if part was bought with
community funds and part with separate funds.
B.1. Income
(1) Dividends, interest, and rents from community property are community income
and must be evenly split. Income from separate property is separate income in
Arizona, California, Nevada, New Mexico, and Washington. Idaho, Louisiana,
Wisconsin, and Texas characterize income from separate property as
community income.
B.2. Deductions
(1) When married taxpayers file separate returns, deductions generally depend on
whether the expenses involve community or separate property. Refer to
Publication 555, section entitled Community Property Laws are Disregarded, for
more information.
B.3. Gains and Losses
(1) Gains and losses are classified as separate or community property depending
on how the property is held. For example, a loss on property, such as rental
property held separately, is a separate loss. On the other hand, a loss on
property, such as a casualty loss on a home held as community property, is a
community property loss. See Publication 544, Sales and Other Dispositions of
Assets, for information on gains and losses.
B.4. Community Property Examples
(1) Example 35. Henry and Mabel are married and filed separate tax returns. They
live in a community property state that treats income from separate property as
community income. Their income during the year is summarized in the following
table as follows:
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(2) Community Property Income
Income Description
Henry
Mabel
Total
Wages
20,000
22,000
42,000
Consulting business
5,000
5,000
Partnership
10,000
10,000
Rent from community
property
25,000
25,000
50,000
Dividends from
separate property
1,000
2,000
3,000
Total community
property income
$51,000
$59,000
$110,000
(3) Considering the facts in this example, Henry would report $55,000 (110,000
divided by 2) and Mabel would report $55,000 ($110,000 divided by 2), on their
separate tax returns. However, Henry would report self-employment tax on the
entire $5,000 from his consulting business.
(4) Note that there are exceptions in all states that treat some items of income as
separate property. Refer to IRM 25.18 and Counsel for additional guidance.
(5) Example 36. Fred and Robin are married and live in a home that they
purchased together. Fred owns a second home that he purchased prior to
marriage. They fell on hard times and Fred became delinquent on the mortgage
of his second home. Because of nonpayment, the bank notified him that it
would foreclose on the home. A month later, the lender approved his loan
modification under a government program and canceled a portion of the
mortgage loan (recourse debt). The taxpayers filed separately. In this example,
SP means separate property and CP means community property in the
following information.
(6) First, determine whether Fred can exclude cancellation of debt income under
the insolvency exclusion. Secondly, determine whether Fred can exclude
cancellation of debt income under the qualified principal residence
indebtedness exclusion. Fred’s canceled mortgage debt $75,000.
(7) Additional facts include Liabilities and Assets immediately before the discharge
of debt:
• Jointly owned liabilities $250,000
• FMV of jointly owned assets $525,000
• Fred’s mortgage (SP) $200,000
• FMV of Fred’s home & assets (SP) $155,000
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(8) Insolvency Calculation
Assets and Liabilities
Fred
Robin
Totals
Liabilities (CP)
125,000
125,000
250,000
Fred's mortgage (SP)
200,000
0
200,000
Total Liabilities
325,000
125,000
450,000
Less:
Assets (CP)
262,500
262,500
525,000
Fred's assets (SP)
155,000
0
155,000
Total Assets
417,500
262,500
680,000
Insolvent
0
0
CODI
75,000
75,000
(9) In summary, Fred was solvent by $92,500 ($325,000 total liabilities minus
$417,500 total assets). Robin was solvent by $137,500 ($125,000 total liabilities
minus $262,500 total assets).
(10) Because Fred purchased the second home prior to marriage, his property is
treated as separate property. Since Fred is solvent, he would report the entire
$75,000 of the canceled debt as other income on his tax return. Robin is not
required to report any of the canceled debt in her income.
(11) Fred cannot exclude the $75,000 under the qualified principal residence
indebtedness exclusion, as the cancelled debt was debt related to his second
home and not his principal residence. Fred does not qualify for any other
exclusion.
IX. Rehabilitation Credit and IRC § 469
A. Background
(1) IRC § 47 allows a tax credit for the rehabilitation of a qualified building as
defined in IRC § 47(c). The credit is an investment tax credit. The rehabilitation
credit applies to costs that are incurred for rehabilitation and reconstruction of
certain buildings. In the case of a building other than a certified historic
structure, a building is not a qualified rehabilitated building unless the building
was first placed in service before 1936. Rehabilitation includes renovation,
restoration, and reconstruction. It does not include enlargement or new
construction. The certified historic credit is co-administered with the National
Park Service and the State Historic Preservation Office.
(2) If the rehabilitation credit is generated by a rental activity, IRC § 469(i) generally
limits the deduction to the tax equivalent of $25,000 (e.g., $7,000 in the 28%
bracket). Furthermore, while the active participation standard is not required for
the rehabilitation credit, it is phased out beginning at modified AGI of $200,000.
Generally, no rehabilitation credit may be deducted if the taxpayer's modified
AGI exceeds $250,000.
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(3) A rehabilitation credit may be generated by a business in which the taxpayer
materially participates (works on a regular, continuous, and substantial basis). If
the credit is generated by a business (not a rental activity) in which the taxpayer
works, it is not limited by the passive loss rules under IRC § 469.
(4) Under IRC § 469(c)(7), beginning in 1994, a qualifying real estate professional
may be able to deduct his entire rehabilitation credit if he/she materially
participates in the rental activity generating the credit. The rehabilitation credit is
reflected on Form 8582 CR, Passive Activity Credit Limitations, which is carried
to Form 3468, Investment Credit, which is carried to Form 3800, General
Business Credit, which is ultimately carried to Form 1040 under other credits.
(5) If the credit is generated by a rental activity or by a business in which the
taxpayer does not materially participate, losses are limited under section 469(i)
to the tax equivalent of $25,000.
(6) It is important to note that a taxpayer cannot deduct a credit of $25,000, but
instead is allowed the tax equivalent of $25,000 for the rehabilitation credit.
Thus, for example, a taxpayer in the 28% bracket could deduct a credit of up to
$7,000.
(7) There have been substantial examination issues where taxpayers failed to limit
the rehabilitation credit to the tax equivalent of $25,000 or failed to consider the
modified AGI limitations. Rehabilitation credits disallowed must be carried
forward. Credits suspended due to the passive loss provisions also must be
carried forward and they cannot be carried back per IRC § 469(b).
B. Audit Hints
(1) Check Form 8582CR for any passive credits that exceed $9,900 (the total
passive credit allowable for a taxpayer in the 39.6% bracket). If there is no Form
8582CR, it is an indicator that the taxpayer ignored the passive limitations.
(2) If adjusted gross income exceeds $250,000, no rehabilitation credit is
deductible (unless the taxpayer has passive income which is relatively rare).
(3) Scrutinize carefully, any large amounts of passive income on Form 8582CR line
6 to verify that the character is truly passive.
(4) For additional information and audit techniques on the rehabilitation credit and
PAL refer to the:
• Rehabilitation Tax Credit Audit Technique Guide or
• Passive Activity Losses Audit Technique Guide
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X. Low Income Housing Credit & IRC § 469
(1) IRC § 42 provides a credit for investment in low-income housing. Virtually all
IRC § 42 properties are owned by partnerships and the low-income credit is a
flow-through item. The IRC § 42 credit is included in the General Business
Credit under IRC § 38(b)(5) and subject to the carryback and carryforward rules
under IRC § 39.
(2) Form 8586, Low-Income Housing Credit, is filed with the taxpayer’s tax return to
claim the credit. The allowable credit (as reported on Schedule K-1) is reported
on line 4 of Part I or line 11 of Part II, depending when the low-income buildings
were placed in service. Form 8582CR is used to determine any passive activity
limitation. IRC § 469(i)(6)(B) provides an exception for IRC § 42 credits; e.g.,
there is no active participation requirement for the $25,000 offset and there is
no phase-out of the credit based on modified Adjusted Gross Income.
Therefore, a taxpayer may use the credit to offset taxable income subject to the
$25,000 limit.
A. IRC § 469 - $25,000 Offset
(1) IRC § 469(i) provides only one $25,000 offset for losses and credits combined.
The sum total of passive losses on Form 8582, line 10 and the credit equivalent
on Form 8582CR cannot exceed $25,000 unless the taxpayer has passive
income.
(2) Under IRC § 469(i)(3)(E), the $25,000 offset is absorbed first by passive losses,
then by any passive activity credit, then by the rehabilitation credit, and finally
by the low income housing credit. If the $25,000 offset is completely used up by
passive losses, no passive credit may be used. For example, if the taxpayer
deducts $25,000 in rental real estate losses under the provisions of IRC §
469(i), no passive credit may be used, unless the taxpayer has passive income.
Similarly, if the taxpayer deducts $20,000 in rental real estate losses, only the
tax deduction equivalent of $5,000 (approximately $1,750 credit for someone in
the 35% bracket) remains for passive credits.
B. Disposition of Passive Activity
(1) On disposition of a passive activity to an unrelated party in a fully taxable
transaction, excess current and suspended losses are fully deductible (after
having been subjected to basis and at - risk limitations). However, IRC § 42
credits are not automatically allowable in full. Instead, the taxpayer has two
choices:
• The taxpayer may elect to increase the basis of the IRC § 42 project (or
an interest therein) by completing Form 8582CR, Part VI, or
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• The taxpayer may continue to carry forward the credit and continue to
claim the credit as the $25,000 offset is available.
(2) If auditing a partnership that lost an IRC § 42 project to foreclosure (or
transaction in lieu of foreclosure), no credit is allowable in the year of the
disposition and the taxpayer may be subject to recapture of a portion of the
credit claimed in prior years.
(3) For additional information and audit techniques on low-income housing credit
and PAL refer to the:
• IRC § 42, Low-Income Housing Credit Audit Technique Guide or
• Low-Income Housing Credit - Guide for Completing Form 8823 or
• Passive Activity Losses Audit Technique Guide
XI. Audit Strategies and Case File Documentation
A. Summary of Real Estate Property Audit Strategies
(1) When a taxpayer defaults on a loan or abandons their property, they may not
have documents related to the sale of the property. Consequently, summonsing
third parties (or third party records) may be necessary. The following list
summarizes the audit strategies discussed in this guide.
• During the initial interview, ask the taxpayer questions to establish the
facts and circumstances that led to the disposition or loan modification. If
CODI was excluded from income, establish whether the taxpayer qualified
to exclude income under the exclusion.
• Pull property records upon receipt of a case to identify property owned
and disposed of and all loans associated with the property.
• A reconciliation of the IRP to the return is a required Minimum Income
Probe step (IRM 4.10.4.3.2 Minimum Income Probes: Nonbusiness
Returns and IRM 4.10.4.3.3 Minimum Income Probes: Individual Business
Returns). During this reconciliation, review the IRP for issuance of a Form
1099-A and/or Form 1099-C. This will help to identify whether or not an
income issue exists, because the taxpayer may not have reported a
foreclosure or other type of disposition on the tax return.
• Request the taxpayer’s calculation of CODI and gain/loss of a property.
Ask about any large, unusual, or questionable items and ask for
supporting documentation when warranted.
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• All mortgages should be included in the calculation of gain/loss and CODI.
(Note: lenders, erroneously, do not always issue Forms 1099-C on all
mortgages, especially second mortgages, or where the second mortgage
is from a different lender). Review property records and consider looking
at prior years’ IRP for Forms 1098. These documents will identify whether
the debt was being paid and, possibly, whether the debt should be
considered in the disposition calculation(s).
• Review the Final Closing Statement for loan modifications and
dispositions. There are a few federal, state, and lender incentives that the
taxpayer may qualify for. Identify whether a loan modification incentive
received is taxable. For dispositions (e.g., short sales), a taxpayer may
receive funds to cover relocation expenses. This may be listed on the
Final Closing Statement as “relocation assistance.” This amount generally
is taxable and should be included in the sales price on Schedule D or
Form 4797.
• When loan or sales information is in question, request the Final Closing
Statement from the lender or search public property records for recorded
loan information, foreclosure notices, grant deed and/or title transfer for
the disposition. The taxpayer might not have a copy of these documents if
the home was foreclosed or disposed through a deed in lieu of
foreclosure. These documents will identify pertinent information such as,
the sales amount, date of title transfer, identifiable event, etc.
• Note that the Final Closing Statement may not list the total debt owed at
disposition. The Final Closing Statement will show the sales price and the
amount of the proceeds that will be applied towards the loan balance right
before the sale. You will need to add the amount forgiven to the sales
price to identify the approximate amount owed right before the disposition.
Also, review property records, the last monthly loan statement, loan
documents, and/or other documents to identify the loan balance owed
right before the disposition.
• Request purchase and refinance documents to determine the adjusted
basis. Ask the taxpayer how the funds were used if the property was
refinanced. Any amount used for personal purposes is not qualified
indebtedness under the principal residence, farm, and real property
business exclusions.
• Request a copy of the insolvency calculation. Ask about any questionable
items and request supporting documentation when warranted. Refer the
taxpayer to Publication 4681 to complete the insolvency worksheet if
insolvency is claimed during the audit. The insolvency exclusion is not an
election and can be utilized even during an examination.
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• As part of the insolvency calculation, look for any liabilities that should
have a corresponding asset. For example, if a car loan is listed, the fair
market value of the vehicle should be listed under assets, unless the
vehicle was repossessed.
• Generally, mortgage lenders will conduct an appraisal of the property
during a short sale process. Therefore, a comparison of the fair market
value on the Forms 1099-A and/or 1099-C with the taxpayer’s insolvency
calculation can be done to identify any differences. If you do identify any
differences, request that the taxpayer explain how they determined the fair
market value of the property particularly if the difference puts the taxpayer
in an insolvent position.
• Sometimes taxpayers attempt to convert their principal residence into
rental real estate property right before it forecloses. Then, the losses and
non-deductible personal expenses (e.g., property insurance) are deducted
as passive losses and deductions, respectively.
• Determine why the taxpayer converted the residence to a rental and
whether it was formally the taxpayer’s principal residence or second home
and the resulting tax consequences.
• Evaluate whether the conversion was temporary or a permanent
conversion to a valid rental activity.
• Non-issuance of a Form 1099-C does not relieve taxpayers of their
responsibility to include CODI in income. Identify all loans on the property
by reviewing IRP and property records. All loans should be considered in
the CODI and gain/loss calculations.
• Consider state foreclosure laws for the state where the property is located.
For example, at times taxpayers are not issued Form 1099. The state law
will help to determine whether the lender forgave any debt.
• When CODI, Form 4797 gain/loss or Schedule D gain/loss, and Schedule
E gain/loss for all years are netted and result in a loss, consider whether
the taxpayer is “poorer” by that amount. If the taxpayer could not afford to
sustain that loss then how did he/she fund the losses (e.g., other debt,
current year income, or other assets)?
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B. Case File Documentation
(1) Cases involving foreclosures should include the following
information/documentation:
• Any document that helps to provide a financial picture of the taxpayer at
the time of the foreclosure. For example, house and car loans, credit card
bills, utility bills, earnings statements, bank statements, check registers,
investment statements, etc.
• Any information evidencing that the debt was not in fact collected
• Any Forms 1099-C or Forms 1099-A
• Completed Form 433-A, Collection Information Statement for Wage
Earners and Self- Employed Individuals, and/or Form 433-B, Collection
Information Statement for Businesses, along with supporting
documentation (as warranted)
• Results of any interview with the taxpayer
• Documents collected from the taxpayer as a result of an interview
• Bankruptcy documents (such as the bankruptcy petition and plan) if the
taxpayer filed a Chapter 7, 11, 12 or 13 bankruptcy at the time of the
foreclosure.
C. Standard Paragraphs and Explanation of Adjustments
(1) See IRM 4.10.10, IRM Exhibit 4.10.10-1, and IRM Exhibit 4.10.10-2 for
standard paragraphs and explanation of adjustments for examinations of
returns.
XII. Job Aids
A. Job Aid 1 - Insolvency Worksheet
(1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and
Abandonments (for Individuals), includes an insolvency worksheet, which may
be helpful.
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B. Job Aid 2 - Sample Information Document Request
(1) Only the applicable information as it relates to the taxpayer should be
requested. General questions may include:
• Was the loan(s) that secured the property recourse or nonrecourse?
Provide the documentation relied upon to make this determination.
• What information was relied upon to determine the gross sales price? How
was the cost basis determined?
• If cancellation of debt was excluded from income, provide the last loan
statement showing the balances for all loans that secured the property
right before the foreclosure, deed in lieu of foreclosure or short sale.
• Provide documentation to support the exclusion of cancellation of debt
income (e.g., insolvency, farm, or real property business computations).
• Provide bankruptcy discharge documents.
• Provide attribute reduction calculations, as applicable.
• What method of depreciation was used to depreciate the disposed
property?
• Provide a copy of the Final Closing Statement or other document(s) for the
sale of the property.
• Did you receive any relocation assistance funds or other monies under a
program? If yes, how much was received and how was it reported on the
tax return?
• Was the loan(s) refinanced anytime during ownership of the property? If
yes, how much was received? How were the funds used?
• Provide a copy of the original purchase loan documentation.
• Provide a copy of the refinanced loan documentation.
• If the property was refinanced and funds were totally or partially used for
the property, provide documentation (e.g., invoices, receipts) that shows
the amount and type of expense.
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(2) Only the applicable information as it relates to the taxpayer should be
requested. A document request for information regarding a loan modification
may include:
• Was any money received from the lender as a result of a loan
modification? If yes, provide the amount received and how it was used.
• Was any money received under a Home Affordable Program? If yes,
provide the amount and where this amount was reported on the tax return.
If the amount was nontaxable, provide the name of the Home Affordable
Program or other program and information that explains the funds were
nontaxable.
• Provide documentation to support the exclusion of cancellation of debt
income (e.g., bankruptcy, insolvency, farm, or real property business
computations).
• Provide documentation to support that the property was used as a
principal residence (e.g., utility bills, driver’s license, etc.). [Note to
examiner: This issue is very factual driven meaning that requested
documentation would depend on the facts and circumstances].
• Provide a copy of the Final Closing Statement for the loan modification.
C. Job Aid 3 - Sample Initial Interview Questions - Principal
Residence
(1) Only the applicable information as it relates to the taxpayer should be asked.
Sample initial interview questions regarding a principal residence reported on
Schedule D may include:
• What is your current address?
• How was the property disposed? (For example, abandonment,
foreclosure, deed in lieu of foreclosure, or short sale).
• Provide a brief history of the events that led to the foreclosure.
• Where did you live before and after the foreclosure?
• What date did you move?
• What date was the property purchased?
• How was the sales amount reported on your return determined?
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• Did the lender give you a monetary incentive to vacate the property? If
yes, how much? Was this amount included in the sales amount reported
on the return?
• How was the cost basis determined?
• Did you refinance during anytime of your ownership of the residence? If
yes, how much did you receive? How were the funds used? (Need amount
used for the principal residence and amount used for other purposes).
• Was the property used as rental property anytime during ownership? If
yes, when? How much? Was the property rented for fair rental value? etc.
• Did the lender forgive you of the outstanding balance after the residence
was sold? If yes, did you receive a Form 1099-C? Was it accurate? What
was inaccurate? If no, did the lender receive a deficiency judgment? How
much? How are you paying for the deficiency?
• If the cancellation of debt income was excluded from income under the
qualified principal residence indebtedness exclusion, was the refinanced
amount considered in the amount excluded from income? (Non-qualified
portion may be taxable CODI).
D. Resources for Real Estate Foreclosures and Cancellation of Debt
Income
(1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and
Abandonments (for Individuals). This publication explains the federal tax
treatment of canceled debts, foreclosures, repossessions, and abandonments.
(2) Passive Activity Loss Audit Technique Guide. This Audit Technique Guide
provides examiners with specific guidance on potential audit issues, issue
identification, lead sheets, and other job aids.
(3) The U.S. Department of Housing and Urban Development. The Department
of Housing and Urban Development administers programs that provide housing
and community development assistance. The Department also works to ensure
fair and equal housing opportunity for all.
