Under IRC § 61(a)(12), a Taxpayer realizes income to the extent of debt forgiveness. Income must be recognized when a taxpayer satisfies or retires a loan for an amount less than the loan’s full face value. The taxable income is the difference between the face amount of the debt and the amount accepted as consideration (in full satisfaction of the debt).
Whether or not the income is subject to tax (as discharge of indebtedness income) depends on whether the indebtedness at issue is recourse debt or non-recourse debt.
If recourse debt (i.e., personal liability), there is discharge of indebtedness income (if the face amount of debt exceeds the fair market value of the property transferred).
If non-recourse debt (i.e., no personal liability), the amount of income arising from discharge of the indebtedness is treated as an amount realized from the sale of the property (and there is no discharge of indebtedness income).
Under Helvering v. Hammel, 311 U.S. 504 (1941), the transfer of real property either by a foreclosure sale or a deed in lieu of foreclosure is treated as a taxable sale or exchange. The taxpayer realizes a gain or loss measured by the difference between the foreclosure proceeds and the taxpayer’s adjusted basis in the property. (See IRC § 103.)
For properties sold at a foreclosure sale, the amount realized (for tax purposes) equals the greater of the sales proceeds, or the face amount of the debt if the sale is to a third party, and equals the bid price if the sale is to the creditor.
Regarding foreclosures:
1) If real property (securing a non-recourse debt) is transferred in exchange for cancellation of the debt, the amount realized (from the sale) includes the principal amount of the debt discharged.
2) If the foreclosure is for the taxpayer’s principal residence, and foreclosure proceeds exceed the taxpayer’s basis, gain may be excluded from income under IRC § 108. (See below.)
3) If the foreclosure’s proceeds are less than the taxpayer’s basis, a loss may not be recognized.
Income from discharge of indebtedness, is includable under gross income, unless it is one of four exclusions (from income) under IRC § 108:
1) A debt discharge in a bankruptcy action under Title 11 of the U.S. Code in which the taxpayer is under the jurisdiction of the Court and the discharge is either granted by or is under a plan approved by the Court.
2) Discharge of qualified farm indebtedness.
3) Discharge of qualified real property business indebtedness.
4) A discharge when the taxpayer is insolvent outside bankruptcy. Insolvency means an excess of liabilities over the fair market value of assets immediately prior to discharge. This exclusion is limited to the amount by which the taxpayer is insolvent.
The taxpayer’s insolvent amount includes the amount by which a non-recourse debt exceeds the fair market value of the property securing the debt, but only to the extent the excess non-recourse debt is discharged.
For tax compliance, Form 982, Deduction of Tax Attributes Due to Discharge of Indebtedness (and § 1082 basis adjustment) is filed with a debtor’s income tax return to report excluded income from the discharge of indebtedness.
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