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Financial Distress Chapter 16 pp. 541-570

Financial Distress Chapter 16 pp. 541-570. 2016 National Income Tax Workbook™. p. 541 Financial Distress . Cancellation-of-Debt Income (CODI) Bad-Debt Deduction Debt-Related Information Returns. p. 542 Cancellation-of-Debt Income .

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Financial Distress Chapter 16 pp. 541-570

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  1. Financial DistressChapter 16 pp. 541-570 2016 National Income Tax Workbook™

  2. p. 541 Financial Distress • Cancellation-of-Debt Income (CODI) • Bad-Debt Deduction • Debt-Related Information Returns

  3. p. 542 Cancellation-of-Debt Income • Transactions triggering tax consequences: • Transfer of assets triggering recognition of gain or loss • Discharge of debt • Recognition of income • Exclusion of income under §108 with reduction of tax attributes

  4. p. 542 Recognition of Gain or Loss • Repossession, forced sale, voluntary sale • Example 16.1 • Bank loan secured by stock • Bank sold the stock and applied to loan • Excess funds to Lotta • Lotta has gain – sales price less basis

  5. p. 542 Recognition of Gain or Loss • Repossession: Property Held for Sale • Cash basis: postpone income by delaying sale - Financial distress can accelerate • Example 16.2 • Deduct crop costs 2016, to sell in 2017 • Bank sells crop, 2016 income = FMV

  6. pp. 542-543 Recognition of Gain or Loss • Repossession: Property Used in Business • Depreciation recapture – ordinary income • Example 16.3 • § 1231 Gain or Loss • Sale at > original cost → § 1231 gain • Sale at < adjusted basis → § 1231 loss • Example 16.4 • Example 16.5

  7. p. 543Inclusion of COD Income • CODI generally = difference between principal owed & amount accepted • Repossession: FMV = borrower payment • Example 16.6 Personal Use Asset • Truck - $23,000 with $20,000 loan • Repossessed: FMV = $12000, Loan = $15,000 • COD income = $3,000 (15-12) • Loss of $11,000 (12-23) not deductible

  8. p. 544COD Income – Special Rules • Related party acquisition • Relative of debtor acquires debt for < face • Debtor has COD income (CODI) • Family = spouse, parents, children (+ spouses) grandchildren • + any related party under §§ 267(b) & 707(b) • Cancellation as gift → no CODI • Discharge w/o repossession → CODI

  9. p. 544Exceptions to COD Income • Bankruptcy • Discharge while debtor in bankruptcy • Insolvency • Liabilities exceed assets immediately before discharge of debt • Exception limited to insolvency amount • Principal Residence (2007-2016) • Qualified personal residence debt

  10. p. 545Exceptions to COD Income • Deductible if paid • If taxpayer made payment, could deduct • Example 16.7 • Interest obligation for cash basis taxpayer • Installment purchase • Owed to original seller → sale price adjustment • Buyer lowers basis by debt discharge

  11. p. 545Exceptions to COD Income • Qualified farm debt • Debt owed to unrelated lender, • Incurred directly in T or B of farming, & • ≥ 50% taxpayer’s aggregate gross receipts for 3 years prior to discharge are from farming

  12. p. 545Exceptions to COD Income • Qualified Real Property Debt • Debtor not a C corporation • Debt incurred to acquire real property used in a T or B and secured by the real property • Not debt incurred for real property held for sale • Excluded amount not to exceed the excess of • Outstanding debt principal just before over • Property FMV net of other debt the property secures

  13. p. 545Exceptions to COD Income • Qualified Real Property Debt (N/A C corp) • Debt to acquire real property used in a TorB & secured by the real property (not held for sale) • Exclusion not to exceed: • Excess of outstanding debt principal just before over property FMV net of other debt it secures • Aggregate adjusted basis of depreciable property (after any basis reductions)

  14. pp. 545-546Exceptions to COD Income • Grantor Trusts and Disregarded Entities • “Taxpayer” for bankruptcy and insolvency exclusions is the owner (not the entity) • § 108 exceptions apply in prescribed order • Practitioner Note, p. 546 • Can elect to apply insolvency exception before qualified personal residence

  15. p. 546Election to Defer COD Income • Election to defer CODI in 2009 and/or 2010 • Defer the income until 2014 → recognize ratably over 5 year period • When deferred CODI recognized, § 108 exclusions will not apply

  16. p. 546Reduction in Tax Attributes • Tax on CODI deferred by reduction in tax attributes • Reductions shown on Form 982 • No reductions if qualifies for “deductible if paid” or installment purchase exception • Reduction rules differ for various exceptions

  17. p. 547Reduction in Tax Attributes • Principal Residence: Reduce residence basis • Qualified Real Property Debt • Reduce basis in depreciable real property • Reduce at earlier of • End of the tax year of discharge • Immediately before property disposition • Bankruptcy, insolvency, qualified farm debt • 7 attributes to reduce in prescribed order

  18. p. 547Reduction in Tax Attributes • NOL • General business credit • Minimum tax credit • Capital loss carryovers • Basis (may elect to apply first) • Limited to basis at beg’g of next year • PAL and passive credit carryovers • Foreign tax credit carryovers

  19. pp. 547-548Student Loans • Debt cancelation tied to working a certain time period in certain professions not CODI if from • A government entity, • Certain tax-exempt public benefit corps, or • An educational institution • Education loan repayments not taxable if from: • NHSC Loan Repayment Program • State program eligible for funds under PHSA • State program for certain health services

  20. p. 548-551Attribute Reduction • Reduced dollar/dollar of exclusion-credits 1 for 3 • Example 16.8 $1,000,000 debt canceled • $1,500,000 insolvent • Figure 16.1 Tax Attributes • Figure 16.2 Form 982 with attachment • Example 16.9 • Save NOL, Elects depreciable basis first • Figure 16.4 Form 982 with attachment

  21. p. 551Attribute Reduction • Tax attributes to zero, CODI remains • Bankruptcy or insolvency: No recognition • Qualified farm debt: Excess CODI taxable • Personal asset basis not reduced • Limit on Basis Reduction: Bankruptcy, Insolvency • Retain basis = debt remaining after discharge • No limit if elects to reduce depreciable first • (No limit - qualified farm debt basis reduction)

  22. pp. 551-552Attribute Reduction • Example 16.10 Insolvent • $75,000 aggregate basis in assets • $100,000 debt, $40,000 discharged • Basis reduction limit: $15,000 (75-60) • Still excludes full $40,000 for insolvency • Rationale to limitation: To prevent tax if remaining assets sold for debt

  23. p. 552Attribute Reduction • Order of Basis Reduction • Real property used in T or B or held for investment (not held for sale) that secured debt • Personal property used in T or B or held for investment (not inventory, receivables) that secured the debt • Remaining property (not inventory, real property held for sale, receivables)

  24. p. 552Attribute Reduction • Order of Basis Reduction • Inventory, notes receivables, accounts receivables, real property held for sale • Property not used in T or B and not held for investment • Example 16.11 • Figure 16.6 Debt and Security • Figure 16.7 Assets

  25. pp. 552-553Attribute Reduction • Example 16.11 (continued) • $180,000 forgiven – No CODI recognition • Basis reduction: Lesser of $180,000 or $150,000 ($600,000 - $450,000) • Debt was secured by real property – reduce building and land by $100,000 • Equipment also secured debt - $50,000 prorated among the machines (using basis) • Figure 16.8

  26. p. 553Attribute Reduction • Qualified farm debt exception: Only property held for use in T or B (or for production of income) is reduced • Depreciable property • Land held for use in farming • Other qualified property • Basis reduction occurs at the end of the tax year of the discharge

  27. p. 554Income vs Gain on Asset Transfer • Whether property transfer when debt canceled is income or gain depends on type of debt • Example 16.12 $500,000 loan canceled • Building FMV: $400,000 Basis: $350,000 • Nonrecourse: $150,000 gain (500-350) • Recourse: COD $100,000 (500-400) Gain $ 50,000 (400-350)

  28. Qualified Personal Residence Debt(QPRI) p. 554 • Example 16.13 • Basis $250,000 • Loan Balance $235,000 FMV $200,000 • Plans to walkaway, let lender foreclose • Q1: Deductible loss? No, personal asset • Q2: Taxable COD income? • $35,000 debt discharge but may exclude as qualified principal residence indebtedness

  29. pp. 554-556QPRI – Example 16.13 • Q3: Tax consequence to the exclusion? • $35,000 basis reduction at beg’g of next year • No other tax attribute affected – Figure 16.10 • Q4: What if prior home office deduction (including $2,500 depreciation) • Cannot treat as 2 properties, no loss deduction

  30. p. 556QPRI – Example 16.13 • Q5: Does it matter if Jason is insolvent or files bankruptcy? • COD income still excluded • QPRI exclusion takes precedence unless Jason elects to apply insolvency exception • If in bankruptcy, cannot elect the QPRI exclusion in place of the bankruptcy exclusion

  31. p. 556QPRI – Example 16.13 • Q6: What if gain on the deemed sale? • Could qualify for exclusion under § 121 • Would he turn the house over if FMV > debt? • Q7: If loan restructured, $35,000 discharge in 2016, house sold in 2017 for $220,000? • Discharge excluded, basis reduced $215,000 • Gain of $5,000 in 2017 • If office depreciated, $2,500 not excludible

  32. Bad Debt Deduction p. 557Business Bad Debts - Definition • Debts created/acquired in the TP’s T or B or • Debts related to TP’s T or B when worthless • Created or acquired in a business • Same idea as whether a loss is Tor B • Example 16.14 • Sold business, retained 2014 rec’ble • 2016 worthless, business debt

  33. Bad Debt Deduction pp. 557-558Business Bad Debts - Definition • Related to business when worthless • Use of funds not of consequence • Example 16.15 • Ex. 16.14 sold receivable with business • New owner did not create/acquire in T or B but related to business when worthless • Q1 If sold debt to sister? Not business debt • Q2 If business inherited by son? Business debt

  34. Bad Debt Deduction pp. 558-559Business Bad Debts • Common business debts • Loans to clients & suppliers • Debts of a partner • Loans to an employer • Loss = basis in the debt • Cash basis A/R → no basis • Accrual basis A/R → basis • Purchased A/R at < face → loss = cost

  35. Bad Debt Deduction p. 559Business Bad Debts – Timing • Method determines timing of deduction • Specific Charge-Off Method • Deduct in year partially or totally worthless • Partially: if charge off in accounting records • Amend: filing + 3 yrs or payment + 2 yrs • Totally: in year worthless net of earlier partial • Amend: filing + 7 yrs or payment + 2 yrs

  36. Bad Debt Deduction p. 559Business Bad Debts - Timing • Specific Charge-Off Method • Deduct in year partially or totally worthless • Partially: can deduct if charge off in accounting records • Totally: deduct in year worthless net of any earlier partial write-off

  37. Bad Debt Deduction p. 560Business Bad Debts - Timing • Nonaccrual-Experience Method • Accrual taxpayers if • Provide services in specified fields • Average annual GR ≤ $5M all prior years • No accrual of service-related income expected to be uncollectible → no bad debt • Cannot use if for lending money, selling goods, acquiring receivables

  38. Bad Debt Deduction p. 560Business Bad Debts - Reporting • Deduct where income reported • Schedule C, Schedule F • Schedule A-2% if employee loan to employer • Example 16.19 – Business Bad Debt • Figure 16.11 – Sched C, Part V

  39. Bad Debt Deduction p. 561Nonbusiness Bad Debts - Definition • Not: • Debts created/acquired in TP’s T or B or • Debts related to T or B when worthless • Must show intended as loan, not gift • Establish true debtor/creditor relationship • Example 16.20 – Gift • Example 16.21 – Enforceable Loan

  40. Bad Debt Deduction pp. 561-562Nonbusiness Bad Debts - Definition • Common nonbusiness bad debts • Lien on property – owner pays off lien, claim against contractor is nonbusiness debt • Example 16.22 • Deposits for goods or services not in T or B • Example 16.23 • Secondary liability on home mortgage • Buyer assumes mortgage & defaults

  41. Bad Debt Deduction pp. 562-563Nonbusiness Bad Debts – Loss • Loss = basis in debt • Example 16.24 – unpaid wages has no basis • Deducted only when totally worthless • Amend later of filing + 7 yrs or paym’t + 2 yrs • Short-term capital loss – Form 8949 • Statement of specifics of debt, efforts to collect and explanation of why worthless • Example 16.25, Figure 16.12

  42. Bad Debt Deduction pp. 563-564Other Bad Debt Rules • Worthless securities • Sale/exchange, capital asset, last day of year • Amend: later of filing + 7 yrs or paym’t + 2 yrs • Loan guarantees • Entered into as T or B or transaction for profit • Entered into before worthless at all • Reasonable consideration received • Legally enforceable

  43. Bad Debt Deduction p. 564Other Bad Debt Rules • Loan guarantees • Reasonable expectation @ agreement that would not have to pay w/o reimb. from debtor • Reasonable consideration not limited to cash or property • Guarantee: favor, no consideration – no debt • Example 16.26 Business loan guarantee • Example 16.27 Investment loan guarantee

  44. Bad Debt Deduction pp. 564-565Other Bad Debt Rules • Loan guarantees • No bad debt in year of payment if has right to replace lender and collect from debtor • No § 163 (interest) § 165 loss deductions • Proving debt worthless • Debtor(s) financial state, FMV of collateral • Took reasonable steps to collect • Bankruptcy of debtor good evidence

  45. Bad Debt Deduction p. 565Other Bad Debt Rules • Recovery of a bad debt • Include all or part in gross income • Limited to amount of bad debt deduction that reduced taxable income • Report as “other income” • Bad debt in NOL still in carryover treated as having reduced taxable income

  46. p. 566Debt-Related Information Returns • 1099-A: Lender acquires interest in secured property in full/partial satisfaction of debt or know that property abandoned • 1099-C: Anyone in T or B of lending or federal government unit canceling debt in excess of $600 • 1099-C only: Debt canceled w/foreclosure or abandonment during the year

  47. pp. 566-567Debt-Related Information Returns • Example 16.28 Building Foreclosure • $100,000 loan, Property FMV $75,000 • Report sale with $75,000 amount realized • Figure 16.14 – Form 1099-A (still owes $25K) • Example 16.29 $50,000 loan cancelled • Figure 16.15 – Form 1099-C • CODI of $50,000, Form 982 if exclusion • Interest not included – deductible if paid

  48. pp. 567-568Debt-Related Information Returns • Example 16.30 • Bank realized $25,000 won’t be collectible • Canceled entire note @ foreclosure • Figure 16.16 • Identifiable events triggering 1099-C • Treas. Reg. § 6050P-1(b)(2)(i) • List – page 568

  49. p. 568Debt-Related Information Returns • Identifiable events triggering 1099-C • Discharge in bankruptcy • Debt rendered unenforceable in a receivership, foreclosure or similar proceeding in court • Cancellation upon expiration of statute of limitations for collection • Cancellation by foreclosure election by creditor that bars rights to pursue collection

  50. p. 568Debt-Related Information Returns • Identifiable events triggering 1099-C • Cancellation pursuant to probate or similar proceeding • Discharge by agreement for less than full consideration • Discharge by creditor based on creditor policy to discontinue collection & discharge debt • Expiration of 36-month nonpayment test period

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