Editor: Michael D. Koppel, CPA/CITP/PFS, MSA, MBA
It comes as an unpleasant surprise to many clients that debt forgiveness is a taxable event. Sec. 61(a)(12) specifically cites discharge of indebtedness as gross income, while Sec. 108 excludes the discharge from gross income if it occurs under specific circumstances (see Sullivan, “Measuring Insolvency Under Sec. 108”). In addition to having some difficult discussions with clients, advisers may face a challenge in determining when cancellation of debt (COD) income should be recognized.
Lenders are required to issue Form 1099-C, Cancellation of Debt, to borrowers for whom the lender has discharged or forgiven debt. However, taxpayers should be aware that a lender’s obligation to issue Form 1099-C may not necessarily coincide with debt forgiveness or a requirement to recognize COD income.
Regs. Sec. 1.6050P-1 provides Form 1099-C reporting guidance to lenders and specifies that reportable debt cancellation is triggered at the occurrence of an “identifiable event” indicating the debt will not be repaid.
Within the regulation are eight circumstances under which an “identifiable event” is deemed to have taken place. One such circumstance is the expiration of a period of time during which there has been no payment or collection activity on the debt. The period of time, the “testing period,” stretches for 36 months (extended for any months during which the lender is precluded from collection due to the borrower’s bankruptcy or prohibitions under state law).
Does this provision mean that taxpayers should consider a debt discharged in a year after the expiration of the 36-month period, regardless of the lender’s reporting or lack thereof? Unfortunately, the COD rules are not clear cut. Regs. Sec. 1.6050P-1(b)(1) states that the eight circumstances are outlined for Form 1099-C reporting purposes only; they do not by themselves indicate whether the taxpayer should include COD in income that year.
The Form 1099-C instructions advise that a debt is deemed canceled at the expiration of the testing period unless the lender can rebut the presumption of cancellation. The deemed cancellation triggers a lender’s obligation to issue Form 1099-C, even though the debt may later be collected.
Much of the guidance regarding the timing of COD income recognition is contained in Tax Court cases that focus on the facts and circumstances of each situation. Such cases have found debt discharge to occur where a formal settlement agreement was reached or where the lender surrendered its security right in the property, among others. IRS Service Center Advice 200235030 (released Aug. 30, 2002) instructs taxpayers to examine the facts and circumstances for assurance that the debt will never be repaid regardless of whether the lender issued Form 1099-C.
It should be noted that if a taxpayer receives Form 1099-C, reports the debt discharge in income, and later repays all or a portion of the debt, the taxpayer may file a claim for tax refund if the limitation period is still open.
The IRS may expect to see COD income reported in the same year the lender issues Form 1099-C, but Tax Court decisions have recognized that facts and circumstances may indicate income ought to have been recognized and taxed in a year other than the lender’s reporting year. It is up to the taxpayer and his or her advisers to correctly identify the appropriate year in which to recognize COD income based on the date it is clear the debt will not be repaid. If the taxpayer does not report the COD income in the same year the Form 1099-C is issued, the taxpayer should attach a statement to his or her return explaining the discrepancy.
Michael Koppel is with Gray, Gray & Gray LLP in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
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