The Tax Gotcha When Debt Settled Outside of Bankruptcy

4226218448_849b2121b0_zAll manners of avoiding tax on cancelled debt are NOT created equal.

I have, up to this point, treated “discharge in a case under Title 11” and “insolvency” as equally effective ways to avoid including cancelled debt in taxable income.

Thirty five years into this practice, I just discovered that there is a world of difference in the long run, after an encounter with a diligent, but ultimately incorrect, tax preparer for a Chapter 13 client.

The issue was whether the debtor must reduce the basis on his home by the amount of debt discharged in his bankruptcy.

In my case the unsecured debt was a whopping $375,000.  The preparer insisted that the client must reduce his basis by that amount upon discharge of the debt in Chapter 13.

That would have effectively eliminated the basis in the home, for purposes of someday calculating capital gain on a sale.  The client was horrified.

IRS Form 982

We’ve all pointed clients who call up clutching a 1099 for cancelled debt to  form 982.  It’s the reply, if you will, to the 1099.

The taxpayer gets to say, yes, this debt was cancelled but it isn’t taxable income because….  There follow the boxes for the applicable reasons that it isn’t includible in income.

Top of the list is bankruptcy.  Second is insolvency.

That’s Part I of the form.

Part II goes on to tell the taxpayer to reduce various tax attributes, like credits, loss carryforwards and basis, by the amount of the debt forgiven.

Line 10a tells you to reduce the basis of non depreciable property.  That, my friends, includes homes.  Ouch.

That line had my client in a panic, as he contemplated a zero basis for his home.

Keep reading

The saving grace, it turns out, is found in IRC 1017(c), which I discovered only after some help from my friends on the NACBA listserve.  This section governs the adjustment of tax attributes when debt is forgiven.

A “special rule” in subsection (c) provides that there is no reduction in basis on assets claimed exempt in a bankruptcy proceeding if the forgiven debt is excluded by reason of bankruptcy.

Whew!  My client’s exempt home, and his historic basis in it, takes no tax hit as a result of his bankruptcy discharge.

Lessons garnered

The first lesson I took away, after the adrenaline rush subsided, is that claiming even underwater property exempt is worthwhile.  The real estate market has turned in many parts of the area I draw from, and today’s underwater house is tomorrow’s gold mine, it seems.

The second lesson applies to comparing the tax consequences of settling debt outside of bankruptcy versus getting a bankruptcy discharge of that debt.

I have been wont to say that the insolvency provision for excluding debt keeps most clients contemplating trying to negotiate debts away from ugly tax consequences.  [ Make sure that the client is really insolvent, by the formula used on Form 982, however.]

But that’s not so for homeowners.  Settle your debts outside bankruptcy when you are insolvent, and you are expected to reduce the basis in your home and, in effect, encounter the tax when you sell the home.

Chalk up another signal advantage for addressing debts in bankruptcy.

Image courtesy of Flickr and Antony Theobald.