How Do I Know if My Client Has CODI?
As with any information for your clients, the key is a thorough interview. Lending institutions are notorious for sending out reporting documents late or, in the case of the client moving, never.
The courts and the IRS have been very specific about what triggers a forgiveness of debt by a lender. They set forth examples and used them as precedence in the IRC and recent Bankruptcy Court cases. These are called “identifiable events” and are defined as follows:
In general. An identifiable event is–
1. A discharge of indebtedness under Title 11 of the United States Code (bankruptcy);
2. A cancellation or extinguishment of an indebtedness that renders a debt unenforceable in a receivership, foreclosure, or similar proceeding in a federal or State court;
3. A cancellation or extinguishment of an indebtedness upon the expiration of the statute of limitations for collection of an indebtedness, or upon the expiration of a statutory period for filing a claim or commencing a deficiency judgment proceeding;
4. A cancellation or extinguishment of an indebtedness pursuant to an election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor’s right to pursue collection of the indebtedness;
5. A cancellation or extinguishment of an indebtedness that renders a debt unenforceable pursuant to a probate or similar proceeding;
6. A discharge of indebtedness pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration;
7. A discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt; or
8. In the case of an entity described in section 6050P(c)(2)(A) through (C), the expiration of the non-payment testing period, as described in Section 1.6050P-1(b)(2)(iv).
In Reed, the Bankruptcy Court for the eastern District of Tennessee held that the simple issuance of a Form 1099C by the lender was not in and of itself an identifiable event, while also citing several cases in other courts that had held the exact opposite view. Up to this point the IRS rulings on this subject have been in line with Reed, with the exception of two older Private letter Rulings.
Remember, that just because we determine your client has CODI does not mean it will end up being taxable. We will cover exemptions and exclusions later in this course.
The determination of taxable gain or loss on the “deemed sale” of a seized asset is a completely separate transaction from the actual reporting of the CODI and we will deal with these deemed sales in the next section.
Let’s deal with CODI on unsecured debt first, as it is by far the easiest.
If a client has CODI for unsecured property they should receive a form 1099C, Cancellation of Debt, from the lender. As long as Box 5 is not blank (recourse or non-recourse debt) then the amount in Box 2 is usually CODI. If there is an amount in Box 3 (Interest included in Box 2) than this may be excluded if the interest would have been deductible on the taxpayers return anyway.
For Example: I received a form 1099C, with $15,000 in Box 2, $5,000 in Box 3 and Box 5 is checked. This was from the cancellation of a business loan for my sole proprietorship. Since I would have been able to deduct the $5000 in interest on my Schedule C if I had paid it, I get to subtract that amount from the total amount in Box 2, making my CODI $10,000.
This same theory applies to the entirety of canceled debt if you would have been able to deduct the debt on your tax return if it had been paid and if you are a cash basis taxpayer. Since you don’t take income into your return until you have it in hand and expenses are deducted at the time they are actually paid, this is a wash.
For Example: If I have a Schedule E for a rental residence and I contracted with a company to paint the house inside and out for $5,000. I then couldn’t get a renter and was unable to pay the contractors so the company forgave the debt. Since you have CODI of $5,000, but you never took the expense as you never actually paid it, you can exclude the CODI.
Most of the controversy in the tax field, at the IRS and in the courts, has to do with secured debt, how to treat it, how to determine the CODI from it, and when and where to report it. So, let’s look at secured debts or debts with collateral pledged against the debt.
If a client has a secured debt in the process of being canceled, they may receive a form 1099A, Acquisition or Abandonment of Secured Property, from the lender or they may receive the 1099C or they may receive both.
The client should receive a Form 1099A if the lender goes into foreclosure or repossession proceedings or the lender knows the property has been abandoned. This may take place in the same tax year or an earlier tax year than the actual cancellation of the debt.
Once the creditor cancels the debt, a Form 1099C is issued, if the debt was more than $600. The debtor may have CODI, if the debt was recourse, as a result of the cancellation if the collateral did not satisfy the total amount of the outstanding debt plus expenses and fees. This may also be true if the debtor did a “workout”, restructure, HAMP, HARP or other federal loan program and still actually owns the collateral or if the debtor refinanced a non-recourse loan into a recourse loan.
NOTE: If the lender seizes the property and forgives the loan in the same tax year the client will probably only receive a Form 1099C and there should be an amount in Box 7 (FMV of Property).
NOTE: If your client receives a Form 1099A and the amount in Box 4 (FMV of the property seized) is less than the amount in Box 2 (Outstanding balance of the loan) you should question them as to whether they have received a Form 1099C yet. The Form 1099C can be a long time in coming as the lender will normally continue to try to collect the loan after the seizure.
Next: Part 4, Deemed Sales