Generally speaking, the tax code taxes all income. If you find a $20 bill on the street, it is taxable (seriously). When you borrow money, you may have better cashflow, but you do not have taxable income because you are legally obligated to pay the money back.
Example: Joe borrows $100,000. Joe has no taxable income because he is obligated to pay the money back. Joe has no increase in income.
When a lender discharges (forgives) a borrower’s debt, the borrower has taxable income because the borrower received money but did not pay it back.
Example: Joe borrows $100,000 and is unable to pay it back. The lender discharges the debt. Joe has debt discharge income because Joe is made better off by the $100,000 loan that he does not have to pay back.
Of course in tax law there are always exceptions. I want to discuss three important exceptions that allow taxpayers to defer (notice I didn’t say exclude) debt discharge income.
Debt Discharge When Taxpayer is Insolvent
Insolvency occurs when the market value of your assets is worth less than your debts. To the extent that you are insolvent, any debt discharge income is not currently taxable.
Example: Joe borrows $100,000. A year later, all of Joe’s assets are worth $150,000 and his debts are $210,000. Joe still owes $100,000 on the debt, he defaults on the loan, and the lender discharges the debt. Joe is insolvent to the tune of $60,000 ($210,000 debt less $150,000 assets). Thus, he can defer $60,000 of the debt discharge income. He is currently taxed on the remaining $40,000 debt discharge income.
Debt Discharge in Bankruptcy
When debt is discharged under Title 11 (bankruptcy), all of the debt discharge income is deferred, even if the taxpayer is not insolvent. This is a much more favorable rule than the insolvency rule because the deferred debt discharge income is not dependent on the taxpayer being insolvent.
Example: Same as above except that Joe declares bankruptcy and the $100,000 debt is discharged. Here, the entire $100,000 is deferred from tax.
Foreclosure & Discharge of Mortgage Debt
There is a special rule for acquisition debt on a principal residence. Acquisition debt is borrowed to finance the acquisition, construction, or substantial improvement of a home—it may include refinance loans, but only to the extent that it refinances acquisition debt. Under this rule, up to $2 million of debt forgiveness can be deferred even if the borrower is not insolvent and not in bankruptcy. Forgiveness can include restructuring the debt or losing the principal residence in foreclosure.
Example: Joe takes out a $100,000 mortgage and buys a $150,000 house. The entire $100,000 mortgage is acquisition debt because it is used to acquire a principal residence. If Joe takes out a home equity loan for $20,000 to fund a vacation and pay off credit cards, the $20,000 home equity loan is not acquisition debt because it is not used to acquire a principal residence.
Say, What’s All This Talk About Deferral?
The policy reason behind the tax relief for debt discharge is that if the taxpayer is insolvent, bankrupt, or has lost his principal residence, the taxpayer is suffering financially and it would be unjust to hit him with taxes on the discharged debt. Especially since he probably doesn’t have the cashflow to pay it.
The tax law defers debt discharge income until the taxpayer is better off financially. This occurs through attribute reduction. This means you have to take the amount of deferred debt discharge income and reduce certain items such as:
- Net Operating Losses (NOLs)
- When your business losses exceed your business income for a year, you have an NOL that can be carried back or forward to offset income in other years
- Your NOLs are reduced by deferred debt discharge income so more of your income will eventually be taxed.
- Thus, you pay the tax when you receive income (and have better cashflow) rather than when your debt was discharged.
- Basis of property
- “Basis” basically means the cost of an asset. If you buy a $10,000 piece of equipment, its basis is $10,000. Basis can be adjusted for items such as depreciation. If you deduct $1,000 of depreciation on the piece of equipment, its basis is now $9,000.
- The higher the basis of an asset, the lower the gain when you sell it. The higher the basis of an asset, the more depreciation you can deduct against it.
- The basis of assets is reduced by deferred debt discharge income so that more of the gain is taxed when you sell the asset, and less depreciation can be claimed against the asset when its basis is reduced.
- Thus, the debt discharge income is eventually recognized when you sell the asset, or through lower depreciation deductions
There are other tax attributes, but I just mentioned the two fun ones. A special note—when you have debt discharge income on your principal residence under the new rule, ONLY the basis of your principal residence is reduced by the deferred discharge income—no other attribute reductions are required. This will be relevant when home acquisition debt is restructured.
One Final Complication
Most mortgage debt is recourse debt, meaning that the lender can come after you for any deficiency after a foreclosure sale. When a foreclosure or short sale occur, there is a debt discharge component and a gain or loss component.
DEBT DISCHARGE = AMOUNT OF DEBT LESS MARKET VALUE OF PROPERTY
GAIN/LOSS = MARKET VALUE OF PROPERTY LESS BASIS
Only the debt discharge component can be deferred under one of the above exceptions. Gain/loss is not affected by the debt discharge rules. On a personal residence, the gain may be excluded under the special $500,000 principal residence gain exclusion, and loss is disallowed as a personal loss.
Example: Jane buys a home for $200,000 with a $150,000 mortgage. Jane loses the home when its market value is $120,000 (and the mortgage is still $150,000).
Debt discharge = amount of debt ($150,000) less market value of property ($120,000) = $30,000. This may be deferred under the special rule for debt discharge on a principal residence.
Gain/loss = market value of property ($120,000) less basis ($200,000). Here, Jane has a loss of $80,000 but it is not deductible because it is a personal loss. If Jane had a gain, it could be excluded under the special $500,000 principal residence gain exclusion (assuming she meets the requirements).
If the foreclosed asset was a business asset, the loss component would be deductible and could offset the debt discharge income.
Fine Print: This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.