How to Apply the Exclusions
As mentioned above, if a client qualifies for one of the five exceptions you should apply that exception first. If there is still possible CODI after the exceptions are applied, then you should work your way through the exclusions in order until you reach the end of the exclusions or the end of the CODI, whichever comes first. We will work a comprehensive example at the end of the text that shows this theory at work.
All of the exclusions are documented on the Form 982 in one way or another. There is also an IRS provided insolvency worksheet for use in determining that exclusion. Some of the exclusions require you to reduce your Tax Attributes. We will define and discuss this as well as the forms later.
Assuming the client still has CODI after applying the exceptions, we start with:
Exclusion #1: Bankruptcy. This is fairly straightforward. If the debt was included in a personal bankruptcy, Chapter 7 or 11 under USC Title 11, and the bankruptcy was completed without being dismissed the debt is totally discharged and there is no CODI. However, if the bankruptcy estate is dismissed or the debt was not included in the bankruptcy, than the CODI comes back into play and we move on to the next exclusion. Reduction of Tax Attributes is required.
Exclusion #2: Insolvency. This is probably the most under used of the exclusions simply because taxpayers and tax professionals do not understand how it works. The simple definition of insolvency is your debts exceed your assets. For CODI purposes you must use the date immediately preceding the date of cancellation of debt on the Form 1099C. If the client receives more than one form a separate worksheet must be accomplished for each canceled debt.
For Example: If I have three Form 1099Cs, dated 1 March, 5 June, and 15 November of the tax year, I will need to complete three separate Insolvency worksheets as my solvency changed after the cancellation of each debt.
When completing the Insolvency worksheet, the biggest error is normally the preparer forgetting to include the debt that was canceled and, if any, the FMV of the collateral seized. Also, clients tend to overestimate, underestimate, or fail to include the FMV of their assets. When you are completing an insolvency worksheet and are listing assets be sure to, literally, list everything the debtor owns from the skin out. Remember the worksheet is for the day immediately before the cancellation transaction. See the discussion on Documentation later.
In the case of Insolvency, the taxpayer’s assets include items that are generally excluded from a creditor’s claim in a bankruptcy and/or other legal proceedings. These assets include available funds in an employer’s retirement account or an IRA, but not funds the taxpayer does not have access to, such as, a pension they can only get if they are vested and they are not yet vested. This does not mean the taxpayer has to give up these assets, it is just that they are included in determining if the CODI is taxable.
Insolvency is determined separately for each spouse in a marriage even if a joint return is filed. This will take some investigation into your state’s laws on community property as well as joint and separate assets gained before and during the marriage.
Exclusion #3. Qualified Farm Indebtedness. A solvent farmer (see how the ordering rules apply here) may exclude canceled farm debt if all of the following qualifications are met:
1. The debt was directly attributable to the operation of the farm.
2. Fifty percent or more of the taxpayer’s total gross receipts for the prior three tax years were from farming.
3. The cancellation was made by a qualified person. This is someone or an organization that is in the business of lending money. This person can not be related to the taxpayer, be the person the farm was acquired from or related to that person, or a person who receives a fee in connection with the taxpayer’s investment in the farm.
Exclusion #4. Qualified real property business debt. The solvent business owner who is not a farmer (ordering rules again) may exclude real property business debt if all of the following qualifications are met:
1. The debt was incurred in connection with real property used in a trade or business.
2. The debt is secured by the real property.
3. The debt was incurred before 1/1/1993 or, if incurred after that date, the debt is qualified acquisition debt (defined below) or debt from the refinancing of qualified property debt incurred before that date.
4. The taxpayer makes the election to apply these rules.
Exclusion #5. Qualified Principal Residence Indebtedness (QPRI). As of the time of this writing, this exclusion was set to expire 12/31/2013 and has not yet been extended by Congress. This exclusion is to assist taxpayers who have possible CODI from the restructuring or loss of their primary residence due to foreclosure. Taxpayers may chose to use this exclusion “out of order” and replace any of the other exclusions, except bankruptcy, with this exclusion.
This exclusion only applies to acquisition debt on the taxpayer’s primary residence. Acquisition debt is the debt incurred to buy, build or substantially improve the primary residence and does not include any home equity debt used for any other reason. QPRI is subject to the rules of acquisition debt limitations and for the definition of principal residence.
If the taxpayer loses the home and has a debt(s) that mixes the acquisition and equity factors, the debts must be figured separately. Therefore, any non-acquisition debt, even if secured by the primary residence, falls into the other exclusions categories in order.
Since most residential mortgages are recourse debt there may be a gain or loss to be reported on the Schedule D, as the repossession is a deemed sale of the residence. For the purposes of this transaction, gain or loss and exclusion of that gain or loss is subject to the same rules pertaining to the normal sale of a primary residence under §121.
For Example: Taxpayer has a home mortgage and recourse debt that is all acquisition debt in the amount of $300,000. The owner’s adjusted basis in the home at the time of foreclosure is $250,000. The loan is foreclosed and the FMV of the home is $280,000. Using the worksheet below see the difference between gain/loss and possible CODI:
Worksheet for Foreclosures and Repossessions Part 1. Figure income from cancellation of debt. (Note: If not personally liable for the debt, there is no income from cancellation of debt. Skip Part 1 and go to Part 2.
7. Enter the amount of debt canceled by the transfer of property 1) _$300,000_
8. Enter the fair market value of the transferred property 2) _$280,000_
9. Income from cancellation of debt. Subtract line 2 from line 1.
If less than zero, enter zero 3) _$20,000_
Part 2. Figure gain or loss from foreclosure or repossession.
10. Enter the smaller of line 1 or line 2. Also include any proceeds
received from the foreclosure sale. (If not personally liable for the
the debt, enter the amount of debt canceled by the transfer of
property.) 4) $280,000
11. Enter the adjusted basis of the transferred property 5) _$250,000_
12. Gain of loss from foreclosure or repossession.
Subtract line 5 from line 4 6) _$30,000_
As you can see, there are two distinct transactions here and the taxpayer has a gain of $30,000 on the “sale” of the home and possibly CODI in the amount of $20,000. Assuming he has owned the home for at least two of the last five years, the $30,000 gain on the “sale” would be reported on the Schedule D and excluded using §121 and the $20,000 of CODI would be excluded on Form 982 under QPRI.