Example.
$4,000 of the Simpson Corporation'sliabilities are cancelled
outside bankruptcy.Immediately before the cancellation, the
SimpsonCorporation's liabilities totaled $21,000 and thefair market
value of its assets was $17,500.Because its liabilities were more than
its assets,it was insolvent. The amount of the insolvency was$3,500
($21,000 - $17,500).
The corporation may exclude only $3,500 of the$4,000 debt
cancellation from income becausethat is the amount by which it was
insolvent.It must also reduce certain tax attributes by the$3,500 of
excluded income. Theremaining $500 of canceled debt must beincluded in
income.
Reduction of Tax Attributes
If a debtor excludes canceled debt from incomebecause it is
canceled in a bankruptcy case orduring insolvency, he or shemust
use the excluded amount to reducecertain tax attributes.
Tax attributesinclude the basis of certain assets andthe losses and
credits listed next.By reducing these taxattributes, tax on the
canceled debt is in partpostponed instead of being entirely forgiven.
Thisprevents an excessive tax benefit from the debtcancellation.
If a separate bankruptcy estate was created,the trustee or
debtor-in-possession must reducethe estate's attributes (but not below
zero) bythe canceled debt. See Individuals underchapter 7 or
chapter 11, later.
IRC 108(b)(1); IRC 108(g)
Order of reduction.
Generally, use theamount of canceled debt to reduce the
taxattributes in the order listed below. However, youmay choose to use
all or a part of the amount ofcanceled debt to first reduce the basis
ofdepreciable property before reducing the other taxattributes. This
choice is discussedlater.
IRC 108(b)(2)(A) and IRC 108(b)(5)(A)
Net operating loss.
First, reduce any netoperating loss for the tax year in which the
debtcancellation takes place, and any net operatingloss carryover to
that tax year.
IRC 108(b)(2)(A)
General business credit carryovers.
Second, reduce any carryovers, to or from thetax year of the debt
cancellation, of amounts usedto determine the general business credit.
IRC 108(b)(2)(B)
Minimum tax credit.
Third, reduce any minimum tax creditthat is available as of the
beginning of the taxyear following the tax year of the
debtcancellation.
IRC 108(b)(2)(C)
Capital losses.
Fourth, reduce any net capitalloss for the tax year of the debt
cancellation,and any capital loss carryover to that year.
IRC 108(b)(2)(D)
Basis.
Fifth, reduce the basis of yourproperty as describedunder
Basis Reduction, later.This reduction applies to the basis
of bothdepreciable and nondepreciable property.
IRC 108(b)(2)(E)
Passive activity loss and credit carryovers.
Sixth, reduce any passive activity loss orcredit carryover from the
tax year of the debtcancellation.
IRC 108(b)(2)(F)
Foreign tax credit.
Last, reduce anycarryover, to or from the tax year of the
debtcancellation, of an amount used to determine theforeign tax credit
or the Puerto Rico andpossession tax credit.
IRC 108(b)(2)(G) and IRC 27
Amount of reduction.
Except for the creditcarryovers, reduce the tax attributes
listedearlier one dollar for each dollar of canceleddebt that is
excluded from income. Reduce thecredit carryovers by 33'1'D='3'/'3' cents foreach dollar of canceled debt that is excludedfrom
income.
IRC 108(b)(3)
Making the reduction.
Make the requiredreductions in tax attributes after figuring thetax
for the tax year of the debt cancellation. Inreducing net operating
losses and capital losses,first reduce the loss for the tax year of
the debtcancellation, and then any loss carryovers to thatyear in the
order of the tax years from which thecarryovers arose, starting with
the earliest year.Make the reductions of credit carryovers in theorder
in which the carryovers are taken intoaccount for the tax year of the
debt cancellation.
IRC 108(b)(4)
Individuals under chapter 7 or chapter 11.
In an individual bankruptcy under chapter 7(liquidation) or chapter
11 (reorganization) oftitle 11, the requiredreduction of tax
attributes must be made to theattributes of the bankruptcy estate,
aseparate taxable entity resulting from the filing ofthe case. Also,
the trustee of thebankruptcy estate must make the choice
ofwhether to reduce the basis of depreciable propertyfirst before
reducing other tax attributes.See the discussionof The
BankruptcyEstate, earlier.
IRC 108(d)(7)
Basis Reduction
If any amount of the debt cancellation is usedto reduce the basis
of assets as discussedunder Reduction of TaxAttributes,
thefollowing rules apply to the extent indicated.
IRC 108(b)(2)(D) and IRC 1017(a)
When to make the basis reduction.
Makethe reduction in basis at the beginning of the taxyear
following the tax year of the debtcancellation. The reduction applies
to propertyheld at that time. See section 1.1017-1of the Income Tax
Regulations for more information.
IRC 1017(a)
Bankruptcy and insolvency reduction limit.
The reduction in basis because of canceled debtin bankruptcy or in
insolvency cannot be morethan the total basis of property
heldimmediately after the debt cancellation, minusthe total
liabilities immediately after thecancellation. This limit does not
apply if anelection is made to reduce basis before reducingother
attributes. This election is discussedlater.
IRC 1017(b)(2)
Exempt property under title 11.
If debt is canceled ina bankruptcy case under title 11 of the
UnitedStates Code, make no reduction in basis forproperty that the
debtor treats as exempt propertyunder section 522 of title 11.
IRC 108(d)(10); IRC 1017(c)(1)
Election to reduce basis first.
You (the estate in the case of an individualbankruptcy under
chapter 7 or 11) maychoose to reduce the basis of depreciableproperty
before reducing any other taxattributes. However, thisreduction of the
basis of depreciable propertycannot be more than the total basis of
depreciableproperty held at the beginning of the taxyear following the
tax year of the debtcancellation.
IRC 108(b)(5)
Depreciable property meansany property subject to depreciation, but
only ifa reduction of basis will reduce the amount ofdepreciation or
amortization otherwise allowablefor the period immediately following
the basisreduction. You may choose totreat as depreciable property
anyreal property that is stock in trade or is heldprimarily for sale
to customers in the ordinarycourse of trade or business. You must
generallymake this choice on the tax return for the taxyear of the
debt cancellation, and, once made,you can only revoke it with IRS
approval. However,if you establish reasonable cause, you may makethe
choice with an amended return or claim forrefund or credit.
IRC 1017(b)(3)
Making elections.
Make the election toreduce the basis of depreciable property
beforereducing other tax attributes as well as theelection to treat
real property inventory asdepreciable property, on Form
982,Reduction of Tax Attributes Due toDischarge of Indebtedness
(and Section 1082 BasisAdjustment).
Reg. 7a.1(d)(1)
Recapture of basis reductions.
If any basis in propertyis reduced under theseprovisions and is
later sold or otherwise disposedof at a gain, the part of the gain
that isfrom this basis reduction is taxable asordinary income. Figure
the ordinary income partby treating the amount of this basis reduction
as adepreciation deduction and by treating any suchbasis-reduced
property that is not already eithersection 1245 or section 1250
property assection 1245 property. In the case ofsection 1250 property,
make thedetermination of what would have been straightline
depreciation as though there had been nobasis reduction for debt
cancellation.Sections 1245 and 1250 and the recapture ofgain as
ordinary income are explainedin chapter 4, Dispositions of
DepreciableProperty, inPublication 544, Sales and
OtherDispositions of Assets.
IRC 1017(d)
Partnerships
If a partnership's debt is canceled becauseof bankruptcy or
insolvency, the rules for theexclusion of the canceled amount from
gross incomeand for tax attribute reduction are applied at
theindividual partner level. Thus, each partner'sshare of debt
cancellation income must be reportedon the partner's return unless the
partner meetsthe bankruptcy or insolvency exclusions explainedearlier.
Then all choices, such as the choices toreduce the basis of
depreciable property beforereducing other tax attributes, to treat
realproperty inventory as depreciable property,and to end the tax year
on the day before filingthe bankruptcy case, must be made by
theindividual partners, not the partnership.
IRC 108(d)(6); IRC 703(b)(2);IRC 1398(b)(2)
Depreciable property.
For purposes of reducingthe basis of depreciable property in
attributereduction, a partner treats his or her partnershipinterest as
depreciable property to the extent ofthe partner's proportionate
interest in thepartnership's depreciable property. This appliesonly if
the partnership makes a correspondingreduction in the partnership's
basis in itsdepreciable property with respect to the partner.
IRC 1017(b)(3)(C)
Partner's basis in partnership.
The allocationof an amount of debt cancellation income to apartner
results in that partner's basis in thepartnership being increased by
that amount. At thesame time, the reduction in the partner's share
ofpartnership liabilities caused by the debtcancellation results in a
deemed distribution, inturn resulting in a reduction of the
partner'sbasis in the partnership. These basis adjustmentsare separate
fromany basis reduction under theattribute-reduction rules
describedearlier.
Sen.Rep. 96-1035
Corporations
Corporations in a bankruptcy proceeding orinsolvency generally
follow the same rules fordebt cancellation and reduction of tax
attributesas an individual or individual bankruptcy estatewould
follow.
Stock for Debt Exchange
If a corporation transfers its stock insatisfactionof indebtedness
and the fair market value of itsstock is less than the indebtedness it
owes, thecorporation has income (to the extent of thedifference) from
the cancellation of indebtedness.After 1994, a corporation can
excludeall or a portion of the income created by thestock for debt
transfer if it is in a bankruptcyproceeding or, if not in a bankruptcy
proceeding,it can exclude the income to the extent it isinsolvent.
However, thecorporation must reduce itstax attributes (to the extent
it has any) by theamount of excluded income.
Stock for debt exception.
The stock for debt exception was repealedfor transfersmade after
1994 unless the corporation filed forbankruptcy (or similar court
proceeding) before 1994.Generally, before1995, a corporation did not
realize incomebecause of such stock for debt exchanges if it wasin
bankruptcy or to the extent it was insolvent.Consequently, there was
no gross income to excludeand no reduction of its tax attributes
wasnecessary. The principal differencebetween the stock for debt
exception and the stockfor debt exchange is that the corporation does
notreduce its tax attributes under the stock for debtexception.
IRC 108(e)(10)
Earnings and profits
The earnings and profits of a corporation donot include income from
the discharge ofindebtedness to the extent of the amount appliedto
reduce the basis of the corporation's propertyas explainedearlier.
Otherwise,discharge of indebtedness income, includingamounts excluded
from gross income, increasesthe earnings and profits of the
corporation (orreduces a deficit in earnings and profits).
IRC 312(l)(1); Sen Rep 96-1035
If there is a deficit in the corporation'searnings and profits and
the interest of anyshareholder of the corporation is terminated
orextinguished in a title 11 or similar case(defined earlier), the
deficit must be reducedby an amount equal to the paid-in
capitalallocable to the shareholder's terminated orextinguished
interest.
IRC 312(l)
S Corporations
For S corporations, the rules for excludingincome from debt
cancellation because ofbankruptcy or insolvency apply at the
corporatelevel.
Net operating losses.
A loss or deduction that is disallowed forthe tax year of the debt
cancellation because itexceeds the shareholders' basis in
thecorporation's stock and debt is treated as a netoperating loss for
that tax year in making therequired reduction of tax attributes for
theamount of the canceled debt.
IRC 108(d)(7)(A&B); IRC 1366(d)
Tax Attribute Reduction
Example
The sample filled-in Form982, Reductionof Tax Attributes Due
to Discharge ofIndebtedness (and Section 1082 BasisAdjustment),
shown in this publicationis based on the following situation.
Tom Smith is in financial difficulty, but hehas been able to avoid
declaring bankruptcy. In1995, he reached an agreement with his
creditors,whereby they agreed to forgive $10,000 of thetotal that he
owed them, in return for his settingup a schedule for repayment of the
rest of hisdebts.
Immediately before the debt cancellation,Tom's liabilities totaled
$120,000 and the fairmarket value of his assets was $100,000 (his
totalbasis in all these assets was $90,000). At thetime of the debt
cancellation, he was consideredinsolvent by $20,000. He can exclude
from incomethe entire $10,000 debt cancellation because itwas not more
than the amount by which he wasinsolvent.
Among Tom's assets, the only depreciableasset is a rental
condominium with an adjustedbasis of $50,000. Of this, $10,000 is
allocable tothe land, leaving a depreciable basis of $40,000.He has a
long-term capital loss carryover to 1996of $5,000.He also has a net
operating lossof $2,000 and a $3,000net operating loss carryover from
1994.He has no other tax attributesarising from the current tax yearor
carried to this year.
Ordinarily, in applying the $10,000 debtcancellation amount to
reduce tax attributes, Tomwould first reduce his $2,000net operating
loss, next his $3,000 net operatingloss carryover from 1994, andthen
his $5,000 net capitalloss carryover. However, he figures that it is
betterfor him to preserve his loss carryovers for the nexttax year.
Tom elects to reduce basis first.He can reduce the depreciable
basis of his rentalcondominium (his only depreciable asset) by$10,000.
The tax effect of doing this will be toreduce his depreciation
deductions for yearsfollowing the year of the debt
cancellation.However, if he later sells the condominium at again, the
part of the gain from thebasis reduction will be taxable as
ordinaryincome.
Tom must file Form 982, as shownhere, with his individual return
(Form 1040)for the tax year of the debt discharge. Inaddition, he must
attach a statement describingthe debt cancellation transaction and
identifyingthe property to which the basis reduction applies.This
statement is not illustrated.
Form 982 for Tom
Smith
How to Get More Information
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