Subprime Lending Controversy Fuels Familiar Tax Issues

Editor: Michael D. Koppel, CPA, PFS

It is difficult to winnow the subprime lending controversy down to a single sentence, a single page, or even a single discipline. Its effects are pervasive. In this environment, few participants or observers are thinking about tax issues. In fact, as in so many other contexts, the tax impact of restructurings, loans, loan discharges, and legal settlements often is not considered until the year after the events occur, when taxpayers prepare their income tax returns. At that point it may be too late to do any tax planning, but there are a few fundamental tax points worth making. Multiple class actions have already been filed (and others are planned) involving lenders and their aggressive lending practices. Some of these cases will inevitably result in mortgages being discharged (in whole or in part) as part of the lawsuits’ settlements.

Discharge of indebtedness (DOI) income (also sometimes called cancellation of indebtedness or COD income) is difficult to explain to clients. They understand that they will have a tax liability when they receive cash, and even when they receive something of value in noncash form (such as gold coins, land, etc.). But when it comes to the discharge or cancellation of debt, the client receives nothing tangible. Nevertheless, the Code is clear that a discharge of indebtedness usually produces gross income subject to tax (Sec. 61(a)(12)).

Example 1: S owes T $1,000. T eventually decides that he is not likely to collect the debt and decides to formally relieve S of the obligation to pay back the $1,000. When T does so, S has income.

Note that in this simple example, it does not matter whether the debt is relinquished because of friendship, fear of litigation, or virtually any other reason. When debt is discharged, it represents income to the person who will no longer have to repay the money.

Many borrowers have no idea that this tax rule exists, and many are surprised when they later find (either from an accountant when preparing a tax return or, even less happily, from the IRS on audit) that they have additional tax liabilities because of such discharge.

Exceptions

There are a few important exceptions to this rule, and these can (but do not always) ameliorate the negative tax impact of the DOI income.

Bankruptcy: Under Sec. 108(a)(1)(A), DOI income is excluded from gross income if the discharge of the debt occurs in a Title 11 bankruptcy case while the taxpayer is under the jurisdiction of the Bankruptcy Court and the discharge of indebtedness is granted by the court or occurs under a bankruptcy plan approved by the court (Sec. 108(d)(2)).

Example 2: B borrows money from C to finance his personal business. Later, Bexperiences financial difficulty and enters Chapter 7 bankruptcy. If the Bankruptcy Court approves the discharge of B’s debt to C, such a discharge should not be taxed as DOI income.

Insolvency: One need not file for bankruptcy to avoid DOI income. If the borrower is insolvent at the time of the discharge, the discharge may not be taxed as DOI income (Sec. 108(a)(1)(B)). However, for this tax protection to apply, the amount of the discharge cannot exceed the amount by which the borrower is insolvent. (See, e.g., Toberman, 294 F3d 985 (8th Cir. 2002).)The term “insolvent” is defined as the excess of liabilities over the fair market value of assets, determined immediately before the discharge (Sec. 108(d)(3)).

Example 3: B has assets of $150 and liabilities of $200. Her creditors agree to cancel the indebtedness in exchange for all of B’s assets. The amount of debt forgiven is $50. B should not realize DOI income because the amount of the debt that has been forgiven ($50) does not exceed the amount by which she was insolvent ($50).

Example 4: B has assets of $150 and liabilities of $200; however, B’s creditors agree to cancel their indebtedness in exchange for only $100 of B’s assets. B should realize $50 of DOI income, since the amount of the forgiven debt ($100) exceeds the amount by which B was insolvent ($50).

Rewritten obligations: Under another rule, there should not be DOI income if the obligation is rewritten in some other way (Regs. Sec. 1.1001-3). This is a curious and very important rule. Generally, the regulations treat a “significant modification” in the terms of a debt instrument as a debt-for-debt exchange (Regs. Sec. 1.1001-3(b)). This generally does not give rise to taxable DOI income, as long as the issue price of the new debt instrument is greater than or equal to the amount of the debt prior to the modification.

Example 5: D owes L $100, to be paid over a period of three months. If D renegotiates with L to pay the $100 over a period of 12 months, no DOI income should be recognized. The issue price of the new debt ($100) is equal to the amount that was owed prior to the modification.

However, if D renegotiates the debt with L so that he has to pay only $50 over a period of six months in full satisfaction of the former debt, D recognizes $50 in DOI income. Here, the issue price ($50) of the new debt instrument is less than the amount owed previously ($100).

As these examples make clear, precisely how something is done is important to the tax result.

Foreclosure

Foreclosures can also have tax effects. A debt can be eliminated in foreclosure, and, as noted above, discharging a debt can trigger a tax. In foreclosure, though, there is an extra factor: the value of the property.

Generally, DOI income results when the mortgage loan eliminated through foreclosure exceeds the value of the foreclosed property, usually determined to be the price paid at the foreclosure sale (Regs. Sec. 1.166-6(b)(2)). However,the bankruptcy or insolvency rules noted above may help prevent clients from having to pay tax. Notably, the IRS website now has a special section for individuals who have lost their homes through foreclosure (www.irs.gov/newsroom/article/0,,id=174022,00.html).

In October 2007, the House passed a bill that would create an exclusion from income for DOI resulting from discharge of qualified principal residence indebtedness (H.R. 3648). At the time of this writing, the bill had been referred to the Senate Finance Committee.

Conclusion

Tax issues are often not mentioned in discussions of the subprime lending controversy. Perhaps this is understandable, since the tax issues inevitably arise primarily on the resolution of these items and not before. Most of these cases are probably a long way from resolution. Nevertheless, it is not too soon to note the tax issues that will arise as the last vestiges of the easy credit that led to the subprime debt controversy are untangled.