It is a fundamental principle of tax law that a debtor who is relieved of an obligation to repay a debt, whether partially or fully, has realized an accession to wealth. Under both the Internal Revenue Code (the “Code”) and case law, such an accession to wealth must be included in the debtor’s gross income, absent an explicit exception to this general rule of inclusion. The income resulting from this debt relief is referred to as “COD Income.”
The general rule of inclusion of COD Income, while in keeping with established tax principles, can add additional financial burdens to those who can least afford it—the welcome relief from a mortgage payment for an individual laid off is curtailed by an unexpected tax bill accompanying the relief. There are, fortunately, a handful of exceptions to this general rule that will provide a taxpayer with an exclusion from gross income for COD Income. The exclusions addressed below are not exhaustive, but are, in the authors’ opinions, the most relevant currently. The nuances of the exclusions discussed below are complex, and this discussion is not intended to be all-encompassing; however, knowledge of the exclusions is an important first step in learning to navigate the rules governing COD Income.
Section 108 Exclusions
The traditional exclusions to COD Income are provided under Section 108 of the Code. Section 108(a) provides five exclusions, and there are a number of additional provisions throughout § 108 that function as exclusions in certain circumstances (i.e., purchase-price reduction, indebtedness contributed to capital). Specifically, § 108(a) provides that gross income does not include any amount that would be includible in gross income due to the discharge, in whole or in part, of indebtedness of the taxpayer if:
(i) the discharge of indebtedness occurs in a title 11 case (the “Bankruptcy Exclusion”);
(ii) the discharge of indebtedness occurs when the taxpayer is insolvent (the “Insolvency Exclusion”);
(iii) the indebtedness discharged is qualified farm indebtedness (the “Farm Indebtedness Exclusion”);
(iv) the indebtedness discharged is qualified real property business indebtedness (the “Real Property Business Exclusion”); or
(v) if the indebtedness discharged is qualified principal residence indebtedness which is discharged, or subject to an arrangement that is entered into and evidenced in writing, before January 1, 2021 (the “Principal Residence Exclusion”).
The Bankruptcy Exclusion only applies if a taxpayer is under the jurisdiction of a court in a case under Title 11 of the United States Code and the discharge of indebtedness is granted by the court or pursuant to a plan approved by the court.
The Insolvency Exclusion applies only to the extent of a taxpayer’s insolvency (defined as the excess of liabilities over the fair market value of assets), and a taxpayer must recognize income to the extent the cancellation of indebtedness makes them solvent.
Farm Indebtedness Exclusion
The Farm Indebtedness Exclusion allows a taxpayer to reduce tax attributes instead of recognizing COD Income, but the exclusion is limited to the sum of the adjusted tax attributes of the taxpayer plus the aggregate adjusted bases of qualified property held by the taxpayer as of the beginning of the taxable year following the taxable year of the discharge.
Real Property Business Exclusion
The Real Property Business Exclusion is only available to taxpayers other than C corporations, and the taxpayer must elect for the exclusion to apply. Such an election ultimately gives the taxpayer the opportunity to reduce the taxpayer’s basis in depreciable real property by the amount of the discharged indebtedness, rather than requiring the recognition of income.
Principle Residence Exclusion
The Principal Residence Exclusion excludes from gross income the cancellation of acquisition indebtedness for a taxpayer’s principal residence up to $2,000,000 ($1,000,000 for married filing separately), if the indebtedness is discharged, or is subject to an arrangement that is entered into and evidenced in writing, before January 1, 2021. A taxpayer who uses the Principal Residence Exclusion is required to reduce their basis in the principal residence (but not below zero).
Application of the Section 108 Exclusions
If multiple exclusions apply to a taxpayer’s discharge of indebtedness, the Code provides the order in which the exclusions must be used. The Bankruptcy Exclusion takes precedence over all other exclusions; the Insolvency Exclusion takes precedence over the Farm Indebtedness Exclusion and Real Property Business Exclusion; and the Principal Residence Exclusion takes precedence over the Insolvency Exclusion, unless a taxpayer elects otherwise.
In order to prevent a taxpayer from receiving an excessive tax benefit from the discharge of indebtedness, a taxpayer will be required to reduce various tax attributes (or, alternatively, the taxpayer may elect to reduce the basis of depreciable property before reducing other tax attributes) by the amount of the indebtedness excluded from income under the Bankruptcy, Insolvency, Farm Indebtedness, and Business Real Property Exclusions. Section 108(b)(2) provides the order in which tax attributes are to be reduced.
Qualification for each exclusion, and subsequent application of such exclusion, is subject to complex requirements in the Code and Treasury Regulations. However, knowledge of the existence of the exclusions and a baseline understanding of when they may apply allows taxpayers and their advisors to better identify any lurking issues that may result from a discharge of indebtedness, whether during the Covid-19 crisis or otherwise.
Additional blogs will be written on more specific aspects of COD Income and exclusions, including specific Covid-19-related exclusions, but this post is intended to provide an overview of the general rules governing discharge of indebtedness.
For any questions on this or any other tax-related matter, please feel free to contact Charles Pulman at firstname.lastname@example.org or by phone at (214) 749-2447 and Annie McGinnis at email@example.com or by phone at (214) 749-2412. This blog was written based on the law as in effect on May 7, 2020.