1. Financial Distress Chapter 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. 543 Inclusion of COD Income
CODI generally = difference between principal owed & amount accepted
Repossession: FMV = borrower payment
Example 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. 544 COD 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. 544 Exceptions 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 ( )
Qualified personal residence debt

10. p. 545 Exceptions 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. 545 Exceptions 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. 545 Exceptions 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. 545 Exceptions 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. 545-546 Exceptions 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. 546 Election 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. 546 Reduction 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. 547 Reduction 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. 547 Reduction 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 Student 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. 548-551 Attribute Reduction
Reduced dollar/dollar of exclusion-credits 1 for 3
Example $1,000,000 debt canceled
$1,500,000 insolvent
Figure Tax Attributes
Figure Form 982 with attachment
Example 16.9
Save NOL, Elects depreciable basis first
Figure Form 982 with attachment

21. p. 551 Attribute 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. 551-552 Attribute Reduction
Example 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. 552 Attribute 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. 552 Attribute Reduction Order of Basis Reduction Example 16.11
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 Debt and Security
Figure Assets

25. pp. 552-553 Attribute Reduction
Example (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. 553 Attribute 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. 554 Income vs Gain on Asset Transfer
Whether property transfer when debt canceled is income or gain depends on type of debt
Example $500,000 loan canceled
Building FMV: $400,000 Basis: $350,000
Nonrecourse: $150,000 gain ( )
Recourse: COD $100,000 ( )
Gain $ 50,000 ( )

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. 554-556 QPRI – 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. 556 QPRI – 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. 556 QPRI – 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. 557 Business 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 rec’ble
2016 worthless, business debt

33. Bad Debt Deduction pp. 557-558 Business Bad Debts - Definition
Related to business when worthless
Use of funds not of consequence
Example 16.15
Ex 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. 558-559 Business 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. 559 Business 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. 559 Business 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. 560 Business 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. 560 Business Bad Debts - Reporting
Deduct where income reported
Schedule C, Schedule F
Schedule A-2% if employee loan to employer
Example – Business Bad Debt
Figure – Sched C, Part V

39. Bad Debt Deduction p. 561 Nonbusiness 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 – Gift
Example – Enforceable Loan

40. Bad Debt Deduction pp. 561-562 Nonbusiness 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. 562-563 Nonbusiness Bad Debts – Loss
Loss = basis in debt
Example – 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. 563-564 Other 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. 564 Other Bad Debt Rules
Loan guarantees
Reasonable 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 Business loan guarantee
Example Investment loan guarantee

44. Bad Debt Deduction pp. 564-565 Other 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. 565 Other 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. 566 Debt-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. 566-567 Debt-Related Information Returns
Example Building Foreclosure
$100,000 loan, Property FMV $75,000
Report sale with $75,000 amount realized
Figure – Form 1099-A (still owes $25K)
Example $50,000 loan cancelled
Figure – Form 1099-C
CODI of $50,000, Form 982 if exclusion
Interest not included – deductible if paid

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

49. p. 568 Debt-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. 568 Debt-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

51. p. 569 Debt-Related Information Returns
Expiration of 36-month nonpayment test period
Identifiable event if 36 months w/o payment
Can be rebutted with significant collection activity or facts at Jan 1 following show debt not discharged
Proposed regs remove 36-month rule in favor of 1099-C only for actual debt discharge

52. p. 569 Debt-Related Information Returns
Form 1099-C not automatically = to CODI
Debt payment in next year shows debt not discharged yet
Triggering event might have been in prior year closed by statute
Form 1099-A not automatically = to CODI
Only notification creditor acquired interest in property or property abandoned

53. pp. 569-570 Debt-Related Information Returns
Notice of deficiency not presumed correct unless IRS has something to prove 1099 document is correct
If IRS meets burden, TP can dispute other items on A or C and shift burden back to IRS
TP must have fully cooperated with IRS
IRS has burden of producing proof in addition to 1099-A or C

54. Questions?