Certain deduction and credit carryovers and decisions that you made in earlier years are taken over by the bankruptcy estate when you file for bankruptcy. These include carryovers of deductions, losses, and credits, your method of accounting, and the basis and holding period of assets. These are referred to as tax attributes.

When the estate is terminated, you assume any remaining tax attributes that were taken over by the estate and generally assume any attributes arising during the administration of the estate. See Attribute carryovers, later under The Bankruptcy Estate, for a list of attributes. Also, see Administrative expenses under The Bankruptcy Estate for a limitation.

The bankruptcy estate's income tax returns are open, upon written request, to inspection by or disclosure to you the individual debtor. The disclosure is necessary so that you can properly figure the amount and nature of the tax attributes, if any, that you must assume when the bankruptcy estate is terminated.

In addition, your income tax returns for the year the bankruptcy case begins and for earlier years are open to inspection by or disclosure to the bankruptcy estate's trustee. See Disclosure of return information, later, under The Bankruptcy Estate.

Bankruptcy law determines which of your assets become part of the bankruptcy estate. Generally, all of your legal and equitable interests become property of the estate. However, you may “exempt” certain property from the estate.

A transfer (other than by sale or exchange) of an asset from you to the bankruptcy estate is not treated as a “disposition” for income tax purposes. This means that the transfer does not result in gain or loss, recapture of deductions or credits, or acceleration of income or deductions. For example, the transfer of an installment obligation to the estate would not accelerate gain under the rules for reporting installment sales.

If you receive any assets from the bankruptcy estate when it terminates, do not treat the transfer as a taxable disposition. You treat these assets the same as the bankruptcy estate would have treated them. This includes using the same basis, holding period, and character of the assets as the bankruptcy estate did before it was terminated.

If you receive abandoned property from the estate, you receive the same basis in the property that the estate had.

As the individual debtor, you cannot carry back any net operating loss or credit carryback from a tax year ending after the bankruptcy case has begun to any tax year ending before the case began. The estate, however, can carry the loss back to offset your pre-bankruptcy income.

If you choose to end your tax year, you do so by filing a return on Form 1040 for the first short tax year on or before the 15th day of the fourth full month after the end of that first tax year.

If you are married, your spouse may also join in the choice to end the tax year, but only if you and your spouse file a joint return for the first short tax year. You must make these choices by the due date for filing the return for the first short tax year. Once you make the choice, it cannot be revoked for the first year; however, the choice does not mean that you and your spouse must file a joint return for the second short tax year.

If your spouse files for bankruptcy later in the same year, he or she may also choose to end his or her tax year, regardless of whether he or she joined in the choice to end your tax year. Because each of you has a separate bankruptcy, one or both of you may have 3 short tax years in the same calendar year. If your spouse had joined in your choice, or if you had not made the choice to end your tax year, you can join in your spouses choice. But if you had made an election and your spouse did not join in the election, you cannot join in your spouse's later election. This is because you and your spouse, having different tax years, could not file a joint return for a year ending on the day before your spouse's filing of bankruptcy.

If you choose to close your tax year, you must annualize your taxable income for each short tax year the same way it is done for a change in an annual accounting period. See Short Tax Year in Publication 538, Accounting Periods and Methods, for information on how to annualize your income and how to figure your tax for the short tax year.

If you elect to end your tax year on the day before filing the bankruptcy case, you must file the return for the first short tax year as explained earlier under Making the election.

If you make this election, you must also file a separate Form 1040 for the second short tax year by the regular due date. You should note on the return that it is the “Second Short Year Return After Section 1398 Election.”

If the bankruptcy case is later dismissed, you (the debtor) must file an amended return to replace any full or short year returns that you filed. Attach a statement to any amended return you file explaining why you are filing an amended return. In this situation, no bankruptcy estate is created for tax purposes. Income that was or would be reported by the bankruptcy estate must be reported on your return.

The gross income of the bankruptcy estate includes any of the debtor's gross income to which the estate is entitled under the bankruptcy law. The estate's gross income also includes any income the estate is entitled to and receives or accrues after the beginning of the bankruptcy case. Gross income of the bankruptcy estate does not include amounts received or accrued by the debtor before the bankruptcy petition date.

The bankruptcy estate may deduct or take as a credit any expenses it pays or incurs, the same way that the debtor would have deducted or credited them had he or she continued in the same trade, business, or activity and actually paid or accrued the expenses. Allowable expenses include administrative expenses, such as attorney fees and court costs. These are discussed later under Administrative expenses.

The bankruptcy estate figures its taxable income the same way as an individual figures his or her taxable income. The estate can take one personal exemption and either individual (itemized) deductions or the basic standard deduction for a married individual filing a separate return. The estate cannot take the higher standard deduction allowed for married persons filing separately who are 65 or older or blind. The estate uses the rates for a married individual filing separately to figure the tax on its taxable income.

Bankruptcy law determines which of the debtor's assets become part of the bankruptcy estate. These assets are treated the same in the estate's hands as they were in the debtor's hands.

A transfer (other than by sale or exchange) of an asset from the debtor to the bankruptcy estate is not treated as a “disposition” for income tax purposes. This means that the transfer does not result in gain or loss, recapture of deductions or credits, or acceleration of income or deductions. For example, the transfer of an installment obligation to the estate would not accelerate gain under the rules for reporting installment sales. The estate is treated the same way the debtor would be regarding the transferred asset.

When the bankruptcy estate is terminated, that is, dissolved, any resulting transfer (other than by sale or exchange) of the estate's assets back to the debtor is not treated as a disposition. This transfer does not result in gain or loss, recapture of deductions or credits, or acceleration of income or deductions to the estate.

The abandonment of property by the estate to the debtor is a nontaxable disposition of property.

The bankruptcy estate must treat its tax attributes the same way that the debtor would have treated them. These items must be determined as of the first day of the debtor's tax year in which the bankruptcy case begins. The bankruptcy estate gets the following tax attributes from the debtor:

Certain tax attributes of the estate must be reduced by any excluded income from cancellation of debt occurring in a bankruptcy proceeding. See Debt Cancellation, later.

If the bankruptcy estate has any tax attributes at the time it is terminated, they are assumed by the debtor.

For bankruptcy cases beginning on or after November 9,1992, treat passive activity carryover losses and credits and unused at-risk deductions as tax attributes that the debtor passes to the bankruptcy estate and the estate passes back to the debtor when the estate terminates. Additionally, transfers to the debtor (other than by sale or exchange) of interests in passive or at-risk activities are treated as exchanges that are not taxable. These transfers include the return of exempt property to the debtor and the abandonment of estate property to the debtor.

If a bankruptcy case begins before November 9,1992, and ends on or after that date, the debtor and the trustee for an individual chapter 7 case (the debtor-in-possession for an individual chapter 11 case) can elect to have these provisions apply. In a chapter 7 case, the election is made jointly by the debtor and the trustee of the bankruptcy estate. In a chapter 11 case, the election is incorporated in the bankruptcy plan. See IRS regulations 1.1398—1 and 1.1398—2 for more information on how to make this election.

The bankruptcy estate is allowed a deduction for administrative expenses and any fees or charges assessed it. These expenses are generally deductible as itemized deductions subject to the 2% floor on miscellaneous itemized deductions. However, administrative expenses attributable to the conduct of a trade or business by the bankruptcy estate or the production of the estate's rents or royalties are deductible in arriving at adjusted gross income.

The expenses are subject to disallowance under other provisions of the lnternal Revenue Code, such as disallowing certain capital expenditures, taxes, or expenses relating to tax exempt interest. These expenses can only be deducted by the estate, and never by the debtor.

If the administrative expenses of the bankruptcy estate are more than its gross income for the tax year, the excess amount may be carried back 3 years and forward 7 years. The amounts can only be carried back or forward to a tax year of the estate and never to the debtor's tax year. The excess amount to be carried back or forward is treated like a net operating loss and must first be carried back to the earliest year possible. For a discussion of the net operating loss, see Publication 536, Net Operating Losses.

The bankruptcy estate may change its accounting period (tax year) once without getting approval from the internal Revenue Service. This rule allows the trustee of the estate to close the estate's tax year early, before the expected termination of the estate. The trustee can then file a return for the first short tax year to get a quick determination of the estate's tax liability.

If the bankruptcy estate itself has a net operating loss, separate from any losses passing to the estate from the debtor under the attribute carryover rules, the bankruptcy estate can carry the loss back not only to its own earlier tax years but also to the debtor's tax years before the year the bankruptcy case began. The estate may also carry back excess credits, such as the general business credit, to the pro-bankruptcy years.

The trustee or debtor-in-possession must pay estimated tax (if any is due) for the bankruptcy estate. See the Instructions to Form 1041—ES, Estimated income Tax for Fiduciaries, for information regarding the dollar limits and exceptions to filing Form 1041— ES and paying estimated tax.

The trustee (or debtor-in-possession) must obtain an employer identification number (EIN) for a bankruptcy estate if the estate must file any form, statement, or document with the IRS. The trustee uses this EIN on any tax return filed for the bankruptcy estate including estimated tax returns. The trustee can obtain an EIN for a bankruptcy estate by filing Form SS— 4, Application for Employer Identification Number. Form SS—4 is available at IRS or Social Security Offices. Trustees representing ten or more bankruptcy estates (other than estates that will be filing employment or excise tax returns) may file a consolidated application to obtain blocks often or more EINs by following the procedures set out in Revenue Procedure89—37, 1989—1 C.B. 919.

The trustee (or debtor in-possession) must withhold income and social security taxes and tile employment tax returns for any wages paid by the trustee (or debtor), including wage claims paid as administrative expenses. Until these employment taxes are deposited as required by the Internal Revenue Code, they should be set apart in a separate bank account to ensure that funds are available to satisfy the liability. If the employment taxes are not paid as required, the trustee may be held personally liable for payment of the taxes. See Publication 15, Circular E, Employer's Tax Guide, for details on employer tax responsibilities.

The trustee has the duty to prepare and file Forms W—2, Wage and Tax Statement, in connection with wage claims paid by the trustee, regardless of whether the claims accrued before or during bankruptcy. If the debtor fails to prepare and file Forms W—2 for wages paid before bankruptcy, the trustee should instruct the employees to file an IRS Form 4852, SUBSTITUTE FOR FORM W-2, WAGE AND TAX STATEMENT OR FORM 1099R, DISTRIBUTIONS FROM PENSIONS, ANNUITIES, RETIREMENT OR PROFIT-SHARING PLANS, IRA'S, INSURANCE CONTRACTS, ETC., with their individual income tax returns.

The debtor's income tax returns for the year the bankruptcy case begins and for earlier years are, upon written request, open to inspection by or disclosure to the trustee. If the bankruptcy case was not voluntary, disclosure cannot be made before the bankruptcy court has entered an order for relief, unless the court rules that the disclosure is needed for determining whether relief should be ordered.

For information concerning the disclosure of the bankruptcy estate's tax return see Disclosure of return in formation, earlier, under Responsibilities of the Individual Debtor.

This publication is not revised annually. Future changes to the forms and their instructions may not be reflected in this example.

On December 15, 1994, Thomas Smith filed a bankruptcy petition under chapter 7. Joan Black was appointed trustee to administer the estate and to distribute the assets.

The estate received the following assets from Mr. Smith:

Also, the estate received a $251,500 capital loss carryover.

Mr. Smith's bankruptcy case was closed on December 31, 1995. During 1995, Mr. Smith was relieved of $70,000 of debt by the court. The estate chose a calendar year as its tax year. Joan, the trustee, reviews the estate's transactions and reports the taxable events on the estate's final return.

The certificate of deposit earned $5,500 of interest during 1995. Joan reports this interest on Schedule B. She completes this schedule and enters the result on Form 1040.

Joan enters the depreciation allowed on Form 4562. She completes the form and enters the result on Schedule E.

The commercial real estate was rented through the date of sale. Joan reports the income and expenses on Schedule E. She enters the net income on Form 1040.

The commercial real estate was sold on July 1, 1995, for $280,000. The property was purchased in 1983 at a cost of $250,000. It was depreciated using straight line depreciation and the total depreciation allowed or allowable as of the date of sale was $120,000. Additionally, $25,000 of selling expenses were incurred. She reports the gain or loss from the sale on Form 4797. She completes the form and enters the gain on Schedule D (Form 1040).

Smith's former residence was sold on September 30, 1995. The sale price was $200,000, the selling expenses were $20,000 and his adjusted basis was $130,000. Joan enters this information on Form 2119. Joan completes Form 2119 and enters the gain on Schedule D (Form 1040).

Joan completes Schedule D, taking into account the $250,000 capital loss carryover from 1994 ($251,500 transferred to the estate minus $1,500 used on the estate's 1994 return). She enters the results on Form 1040.

Joan completes page 1 of the 1040 and enters the adjusted gross income on the first line of Form 1040, page 2.

During 1995, the estate paid mortgage interest and real property tax on Mr. Smith's former residence. It also paid income tax to the state. Joan enters the mortgage interest, real estate tax and income tax on Schedule A. Also, she reports the estate's administrative expenses as a miscellaneous deduction subject to the 2% floor. She completes the Schedule A and enters the result on page 2 of Form 1040.

Joan determines the estate's taxable income and figures its tax using the tax rate schedule for married filing separately. She then enters the estate's estimated tax payments and figures the amount the estate still owes.

Joan completes the Schedule D worksheet for capital loss carryover. Because $70,000 of debt was canceled, Joan must reduce the tax attributes of the estate by the amount of the canceled debt. See Debt Cancellation, later. In 1996, Thomas Smith (the individual) will assume the estate's tax attributes. Mr. Smith will assume a capital loss carryover of $3,500 ($73,500 carryover minus the $70,000 attribute reduction).

Joan enters the total tax, estimated tax payments, and tax due from Form 1040 on Form 1041. She completes the identification area at the top of Form 1041, then signs and dates the return.

If you are a trustee, receiver, or an assignee of a corporation that is in bankruptcy, receivership, dissolution, or in the hands of an assignee by court order, you may apply to your IRS District Director for relief from filing federal income tax returns for the corporation. To qualify, the corporation must have ceased business operations and must have neither assets nor income.

Your request to the District Director must include the name, address, and employer identification number of the corporation and a statement of the facts (with any supporting documents) showing why you need relief from the filing requirements. You must also include a statement that you are making the request and furnishing the information under penalties of perjury. The District Director will act on your request within 90 days.

The trustee of the bankruptcy estate may request a determination of any unpaid liability of the estate for tax incurred during the administration of the case by the filing of a tax return and a request for such a determination with the internal Revenue Service. Unless the return is fraudulent or contains a material misrepresentation, the trustee, the debtor, and any successor to the debtor are discharged from liability for the tax upon payment of the tax:

To request a prompt determination of any unpaid tax liability of the estate, the trustee must file a written application for the determination with the IRS District Director for the district in which the bankruptcy case is pending. The application must be submitted in duplicate and executed under the penalties of perjury. The trustee must submit with the application an exact copy of the return (or returns) filed by the trustee with the IRS for a completed tax period, and a statement of the name and location of the office where the return was filed. On the envelope write “Personal Attention of the Special Procedures Function. DO NOT OPEN IN MAILROOM.”

The IRS examination function will notify the trustee within 60 days from receipt of the application whether the return filed by the trustee has been selected for examination or has been accepted as filed. If the return is selected for examination, it will be examined as scon as possible. The examination function will notify the trustee of any tax due within 180 days from receipt of the application or within any additional time permitted by the bankruptcy court.

Generally, the bankruptcy court has authority to determine the amount or legality of any tax imposed on the debtor or the estate, including any fine, penalty, or addition to tax, whether or not the tax was previously assessed or paid.

The bankruptcy court does not have authority to determine the amount or legality of a tax, fine, penalty, or addition to tax that was contested before and finally decided by a court or administrative tribunal of competent jurisdiction (that became res Judicata) before the date of filing the bankruptcy petition.

Also, the bankruptcy court does not have authority to decide the right of the bankruptcy estate to a tax refund until the trustee of the estate properly requests the refund from the Internal Revenue Service and either the Service determines the refund or 120 days pass after the date of the request.

If you (the debtor) have already claimed a refund or credit for an overpayment of tax on a properly filed return or claim for refund, the trustee may rely on that claim. Otherwise, if the credit or refund was not claimed by you, the trustee may make the request by filing the appropriate original or amended return or form with the District Director for the district in which the bankruptcy case is pending. On the return or claim for refund write “Personal Attention of the Special Procedures Function. DO NOT OPEN IN MAILROOM.”

The filing of a bankruptcy petition automatically results in a stay (suspension) of any U.S. Tax Court proceeding to determine your tax liability as the debtor. This stay continues until one of the acts removing it occurs. The stay may be lifted by the bankruptcy court upon your request, the request of the IRS, or the request of any other party in interest. Because the bankruptcy court has power to lift the stay and allow you to begin or continue a Tax Court case involving your tax liability, the bankruptcy court has, in effect, during the pendency of the stay, the sole authority to determine whether the tax issue is decided in the bankruptcy court itself or in the Tax Court.

In any bankruptcy case, the 90—day period for filing a Tax Court petition, after the issuance of the statutory notice of deficiency, is suspended for the time you are prevented from filing the petition because of the bankruptcy case, and for 60 days thereafter. However, even if the statutory notice was issued before the bankruptcy petition was filed, the suspension exists if any part of the 90—day period remained at the date the bankruptcy petition was filed.

The trustee of your bankruptcy estate in any title 11 bankruptcy case may intervene, on behalf of the estate, in any proceeding in the U.S. Tax Court to which you are a party.

Generally, the automatic stay rules prevent a creditor from taking actions to collect prepetition debts. However, the automatic stay does not apply to:

Any tax lien that attaches to the estate's property because of an assessment described above can only take effect when the property (or its proceeds) are transferred back to the debtor. Also, the tax must be the debtor's debt that will not be discharged in the case.

In bankruptcy cases other than those of individuals filing under chapter 7 or 11, and in receivership proceedings where substantially all the debtor's property is in the hands of the receiver, current and earlier returns of the debtor are, upon written request, open to inspection by or disclosure to the trustee or receiver, but only if the Internal Revenue Service finds that the trustee or receiver has a material interest which will be affected by information on the return.

In bankruptcy, the debtor's debts are assigned priorities for payment. Most of the prepetition tax debts are classified as eighth priority claims. Generally, prepetition taxes are certain income and other taxes that the debtor is considered to owe before he or she files a bankruptcy petition.

The following federal taxes, if unsecured, are prepetition eighth priority taxes of the government:

For a chapter 7 case, the preceding eighth priority prepetition taxes may be paid out of the assets of the bankruptcy estate to the extent there are assets remaining after paying the claims of secured creditors and other creditors having higher priority claims.

Different rules apply to payment of eighth priority prepetition taxes under chapters 11, 12, and 13:

Certain taxes are assigned a higher priority for payment. Taxes incurred during administration by the bankruptcy estate are paid first, as administrative expenses. Taxes arising in the ordinary course of your business or financial affairs in an involuntary bankruptcy case, after the filing of the bankruptcy petition but before the earlier of the appointment of a trustee or the order for relief are included in the second priority of payment. The employee's portion of the employment taxes on the first $4,000 (to be adjusted 4/1/98) described in (5) above is included in the third priority.

A penalty for failure to pay tax, including failure to pay estimated tax, will not be imposed for any period during which a title 11 bankruptcy case is pending, under the following conditions. If the tax was incurred by the bankruptcy estate, the penalty will not be imposed if the failure to pay resulted from an order of the court finding probable insufficiency of funds of the estate to pay administrative expenses. If the tax was incurred by you as the debtor, the penalty will not be imposed if:

This relief from the failure-to-pay penalty does not apply to any penalty for failure to pay or deposit tax withheld or collected from others and required to be paid over to the U.S. government. Nor does it apply to any penalty for failure to timely file a return.

An employer is generally allowed a credit against the federal unemployment tax (FUTA) for contributions made to a state unemployment fund, if the contributions are paid by the last day for filing an unemployment tax return for the tax year. If the contributions to the state fund are paid after that date, generally only 90% of the otherwise allowable credit may be taken against the federal unemployment tax.

However, for any unemployment tax on wages paid by the trustee of a title 11 bankruptcy estate, if the failure to pay the state unemployment contributions on time was without fault by the trustee, the full amount of the credit is allowed.

In a title 11 bankruptcy case, the period of limitations for collection of tax (generally, 10 years after assessment) is suspended for the period during which the Internal Revenue Service is prohibited from collecting, plus 6 months thereafter.

If you complete all payments under a chapter 13 debt adjustment plan for an individual with regular income, the court may grant you a discharge of debts, including a discharge of the second and eighth priority prepetition taxes described earlier. However, if you fail to complete all payments under the plan, these taxes are not discharged although the court may grant a discharge of other debts in limited circumstances.

If the cancellation of debt occurs in a title 11 bankruptcy case, the bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, or qualified real property business indebtedness exclusions.

To the extent that the taxpayer is insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions.

A bankruptcy case is a case under title 11 of the United States Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.

None of the debt canceled in a bankruptcy case is included in your gross income in the year canceled. Instead, certain losses, credits, and basis of property must be reduced by the amount of excluded income (but not below zero). These losses, credits, and basis in property are called tax attributes and are discussed under Reduction of Tax Attributes, later.

You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.

Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.

Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below. However, you may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. This choice is discussed later.

First, reduce any net operating loss for the tax year in which the debt cancellation takes place, and any net operating loss carryover to that tax year.

Second, reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit.

Third, reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation.

Fourth, reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.

Fifth, reduce the basis of your property as described under Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property.

Sixth, reduce any passive activity loss or credit carryover from the tax year of the debt cancellaton.

Last, reduce any carryover, to or from the tax year of the debt cancellation, of an amount used to determine the foreign tax credit or the Puerto Rico and possession tax credit.

Except for the credit carryovers, reduce the tax attributes listed earlier one dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 33⅓ cents for each dollar of canceled debt that is excluded from income.

Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation, in reducing net operating losses and capital losses, first reduce the loss for the tax year of the debt cancellation, and then any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. Make the reductions of credit carryovers in the order in which the carryovers are taken into account for the tax year of the debt cancellation.

In an individual bankruptcy under chapter 7 (liquidation) or chapter 11 (reorganization) of title 11, the required reduction of tax attributes must be made to the attributes of the bankruptcy estate, a separate taxable entity resulting from the filing of the case. Also, the trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes. See the discussion of The Bankruptcy Estate, earlier.

Make the reduction in basis at the beginning of the tax year following the tax year of the debt cancellation. The reduction applies to property held at that time. See section 1.1017—1 of the Income Tax Regulations for more information.

The reduction in basis because of canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later.

If debt is canceled in a bankruptcy case under title 11 of the United States Code, make no reduction in basis for property that the debtor treats as exempt property under section 522 of title 11.

You (the estate in the case of an individual bankruptcy under chapter 7 or 11) may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.

Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. You may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. You must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, you can only revoke it with IRS approval. However, if you establish reasonable cause, you may make the choice with an amended return or claim for refund or credit.

Make the election to reduce the basis of depreciable property before reducing other tax attributes as well as the election to treat real property inventory as depreciable property, on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain that is from this basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of this basis reduction as a depreciation deduction and by treating any such basis reduced property that is not already either section 1245 or section 1250 property as section 1245 property. In the case of section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation. Sections 1245 and 1250 and the recapture of gain as ordinary income are explained in chapter 4, Dispositions of Depreciable Property, in Publication 544, Sales and Other Dispositions of Assets.

For purposes of reducing the basis of depreciable property in attribute reduction, a partner treats his or her partnership interest as depreciable property to the extent of the partner's proportionate interest in the partnership's depreciable property. This applies only if the partnership makes a corresponding reduction in the partnership's basis in its depreciable property with respect to the partner.

The allocation of an amount of debt cancellation income to a partner results in that partner's basis in the partnership being increased by that amount. At the same time, the reduction in the partner's share of partnership liabilities caused by the debt cancellation results in a deemed distribution, in turn resulting in a reduction of the partner's basis in the partnership. These basis adjustments are separate from any basis reduction under the attribute-reduction rules described earlier.

The stock for debt exception was repealed for transfers made after 1994 unless the corporation filed for bankruptcy (or similar court proceeding) before 1994. Generally, before 1995, a corporation did not realize income because of such stock for debt exchanges if it was in bankruptcy or to the extent it was insolvent. Consequently, there was no gross income to exclude and no reduction of its tax attributes was necessary. The principal difference between the stock for debt exception and the stock for debt exchange is that the corporation does not reduce its tax attributes under the stock for debt exception.

A loss or deduction that is disallowed for the tax year of the debt cancellation because it exceeds the shareholders' basis in the corporation's stock and debt is treated as a net operating loss for that tax year in making the required reduction of tax attributes for the amount of the canceled debt.

To order free publications and forms, call 1—800—TAX— FORM (1—800—829—3676). You can also write to the IRS Forms Distribution Center nearest you. Check your income tax package for the address. Your local library or post office also may have the items you need.

For a list of free tax publications, order Publication 910, Guide to Free Tax services. It also contains an index of tax topics and related publications and describes other free tax information services available from IRS, including tax education and assistance programs.

If you have access to a personal computer and modem, you also can get many forms and publications electronically. See How To Get Forms and Publications in your income tax package for details. If space permitted, this information is at the end of this publication.

You can call the IRS with your tax questions. Check your income tax package or telephone book for the local number, or you can call 1—800—829—1040.

If you have access to TDD equipment, you can call 1—800—829—4059 to ask tax questions or to order forms and publications. See your income tax package for the hours of operation.