Discussion:Chapter 13 (or insolvency) and COD reduction of attributes

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Discussion Forum Index --> Advanced Tax Questions --> Chapter 13 (or insolvency) and COD reduction of attributes


Discussion Forum Index --> Tax Questions --> Chapter 13 (or insolvency) and COD reduction of attributes

EZTAX (talk|edits) said:

10 June 2011
Client is in Chapter 13 bankruptcy and will be making payments to the trustee for the next 5 years. Seems like COD will not be triggered until the 5 year period is up since the amount of the COD is uncertain until then. Is this accurate?

Mscash (talk|edits) said:

11 June 2011
COD liability will be discharged in the proceeding.

DaveFogel (talk|edits) said:

11 June 2011
I agree. COD income is triggered on the date that the bankruptcy court approves or confirms the Chapter 13 plan.

EZTAX (talk|edits) said:

12 June 2011
But the amount of debt discharged is not known util the end of the payments. How can the COD income be recognized before then? Is it based on the assumption that all payments will be made?

DaveFogel (talk|edits) said:

12 June 2011
There are certain debts specified in the Chapter 13 plan that will never be paid. COD income for those debts is required to be recognized at the time that the plan is approved or confirmed by the bankruptcy court. A debt is viewed as having been discharged the moment it becomes clear that it will never have to be paid. Cozzi v. Commissioner, 88 T.C. 435, 445 (1987); Friedman v. Commissioner, T.C. Memo. 1998-196.

EZTAX (talk|edits) said:

13 June 2011
Thanks Dave - that makes sense. So I guess I need to see the bankruptcy docs. And then the debts that are not immediately forgiven and are part of the payment plan will have COD after the payment plan ends?

DaveFogel (talk|edits) said:

13 June 2011
I can't make a blanket statement that debts that are part of the payment plan aren't canceled. It could be that parts of those debts were canceled. You'll just have to review the bankruptcy docs. You can get them online by subscribing to PACER (Public Access to Court Electronic Records), http://www.pacer.gov/

EZTAX (talk|edits) said:

13 June 2011
In the last few years it has increasingly felt as if you need a tax lawyer on staff in order to attempt to prepare some of these returns.

If a second mortgage is forgiven immediately upon entering into a chapter 13 payment plan, and then a few years later the payment plan “blows up” can the lender reinstate the loan? In other words is the loan forgiveness contingent on the payment plan agreement being fulfilled?

DaveFogel (talk|edits) said:

13 June 2011
You're right -- you do need a lawyer -- but not a tax lawyer, a bankruptcy lawyer because you are asking a question about bankruptcy law. Perhaps someone with bankruptcy law expertise will answer your question here.

DJCCPA (talk|edits) said:

13 June 2011
One of the benefits of filing Chapter 13 is that debt is forgiven with no tax implications. This is why it's preferable to trying to settle with debtors yourself. Settlement may work for some; however there is the issue of the 1099 for the debt forgiven and it is not unheard of for the OC (original creditor) to sell the amount they "forgave" to a JDB - not kosher, but debt collection is an ugly business. So the timing of the debt forgiveness is irrelevant to your client's tax situation. And your original impulse was correct ~ a Chapter 13 does not officially discharge debt until the discharge date - which is at the end of the five years. Plan confirmation does not discharge debt. Plan confirmation simply enforces the automatic stay during the duration of the plan - it "freezes" everything. In fact, a debtor can make payments for years and fail to make payments in months 48, 49, etc. and can run the risk of having their bankruptcy dismissed. If this happens, the creditors are allowed to tack on all of the accrued interest and the debt "exists" again. It doesn't matter how close the debtor was to finishing. This is why Chapter 13's have a high failure rate.

DaveFogel (talk|edits) said:

14 June 2011
"a Chapter 13 does not officially discharge debt until the discharge date - which is at the end of the five years."

What's your authority for this statement? I stated my authority above, and it is confirmed by IRS Letter Ruling 8928012.

I had a client whose Chapter 13 plan did not provide for any payments towards the debts secured by two rental properties that were "under water," so those two debts would never be paid. Those two debts were canceled when the bankruptcy court confirmed the plan, not later when the client made payments towards other debts.

DJCCPA (talk|edits) said:

14 June 2011
Discharge means exactly that - discharge. Discharge occurs at the end of the payment plan in a Chapter 13. Your client's story seems incomplete as you're referring to secured debt. Secured debt usually must be current while in a Chapter 13 - this is what allows people to keep their home more often in a Chapter 13 than in a Chapter 7. Secured debt may be paid outside of the plan with the trustee's permission. Sometimes the trustee will have secured payments within the plan - varies by district. Did your client surrender the properties? If they were surrendered, the asset would go back to the creditor and the remaining debt would then become unsecured debt vs. secured debt. In that case, it is very possible the debt would not be paid as the trustee would deem the debt covered by the asset and not allocate any of the percentage payback to the remaining unsecured debt. There is also the possibility of your client having successfully navigated a lien strip if the debt was a second mortgage. Bankruptcy law is rather complex. Such as the 910 day rule regarding auto loans. My authority is unfortunately from having to understand my life for the next three years. We are on payment number 25 of our Chapter 13 and I've (unfortunately) become quite proficient in bankruptcy law and its implications as I successfully filed pro se. I will be throwing myself a little party when my debt is discharged in April, 2014. For the purposes of the original posters question, the most important thing to remember is that debt discharged in a 13 has zero tax implications. Otherwise, there would be much less benefit to doing it, especially if you lived in a state with a decent SOL and laws against garnishment.

DJCCPA (talk|edits) said:

14 June 2011
The short answer to the original question is that there is NO COD income - that's one of the very few benefits of bankruptcy. I, honestly, can't think of many others. It's an arduous journey.

DJCCPA (talk|edits) said:

14 June 2011
http://www.irs.gov/individuals/article/0,,id=179414,00.html

DJCCPA (talk|edits) said:

14 June 2011
http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics/Chapter13.aspx

Dave, I wonder if your previous client had filed BK prior to the 2005 laws? The 2005 laws changed bankruptcy law drastically.

But for the purposes of the original question, I feel we may be debating a moot point. I'm assuming (perhaps incorrectly) that EZTax's question regarding debt forgiveness related to understanding "when" the event occurred so that the taxable implications could be calculated. As there is no taxable implication, the rest of the argument becomes immaterial to his purposes.

DaveFogel (talk|edits) said:

14 June 2011
DJCCPA, first, nothing in the two links you provided addresses the issue we're discussing. I stand by what I said earlier, which is that a debt is viewed as having been discharged the moment it becomes clear that it will never have to be paid. Cozzi v. Commissioner, 88 T.C. 435, 445 (1987); Friedman v. Commissioner, T.C. Memo. 1998-196. If the taxpayer's Chapter 13 plan doesn't provide for any payments against debt secured by "under water" properties, do you really think that the IRS will take the position that those debts were not discharged until 5 years later? Good luck with that argument.

Second, my client filed for bankruptcy after 2005.

Third, it is not a moot point that we're debating because under IRC §108(b)(2), COD income excluded under the bankruptcy exclusion requires reduction of the taxpayer's tax attributes. The IRS would want those tax attributes to be reduced sooner rather than later.

DJCCPA (talk|edits) said:

14 June 2011
Dave, I think we're talking about two different entities. Your IRS Ruling discusses Chapter 12 and Chapter 11 specifically. These bankruptcy chapters are for businesses. Chapter 13 and Chapter 7 are for individuals. The original poster is inquiring about a Chapter 13 client. I am assuming (based on the Chapter notation) that he is asking about an individual. Unless his client has rental properties, etc. what tax attributes would be adjusted? A business would have to go through the process you've described, I agree 100%.

I think part of the problem is that the original poster didn't give enough information. OK, great, they're in Chapter 13 so they're making payments. If they're an individual who owns a principal residence and credit card debt, what exactly is the effect of the BK on their 1040? The discharged debt is not taxable income. In my case, by surrendering your secured asset, the bank will lift the automatic stay to proceed with a regular foreclosure. The bankruptcy protects me from a deficiency judgment after the sale of the asset (I live in a deficiency state). I do not recognize a personal loss and any debt forgiven is not taxable to me.

If the original poster is asking about properties held in business activities, then, yes, we have to dig deeper. But he didn't ask that. Are we just assuming that and giving him way more information than he may need?

DaveFogel (talk|edits) said:

14 June 2011
"I think we're talking about two different entities. Your IRS Ruling discusses Chapter 12 and Chapter 11 specifically."

The letter ruling I cited involved Chapter 12, which, as I understand it, is the same as Chapter 13 for an individual except that Chapter 12 is for entities. You said that the ruling addresses Chapter 11 specifically, but the taxpayer in that ruling had not filed for Chapter 11. The IRS mentioned Chapter 11 only in passing.

"Unless his client has rental properties, etc. what tax attributes would be adjusted?"

There are seven categories of tax attributes listed in IRC §108(b)(2). In my experience, the most common categories of tax attributes that must be reduced for individual taxpayers are NOL carryovers, capital loss carryovers and the basis of property. Note that the basis of property includes business, investment and personally-used property.

"If they're an individual who owns a principal residence and credit card debt, what exactly is the effect of the BK on their 1040?"

Assuming that they get to keep the principal residence, then they would have to reduce the basis of the residence by the COD income excluded under the bankruptcy exclusion. Real property is reduced before personal property. See Reg. 1.1017-1(a).

DJCCPA (talk|edits) said:

14 June 2011
hmmmm.....I'm thinking around some corners now (which I like, so thank you).

I agree with the above. None of this affected me personally as I surrendered my personal residence and I'm (STILL) waiting on foreclosure over two years later.

In a Chapter 13, the typical way to keep your residence is to continue making payments. In fact, most attorneys will advise any potential bankruptcy client to stop paying everything with the exception of the secured debt items you wish to retain. They need to be up-to-date at filing or have arrears payments built into the plan or the creditor will probably respond with an objection.

So if an individual were to continue their secured payments to their mortgage as part of their plan, there would be no debt forgiveness or discharge on the mortgage (let's say there is no second mortgage here that someone is trying to lien strip). The debtor is simply having their unsecured debt included in the plan.

The basis in their residence should remain unchanged, yes?

DaveFogel (talk|edits) said:

14 June 2011
Of course.

EZTAX (talk|edits) said:

14 June 2011
Thanks for the discussion. Client lost rental property and kept home. My concern is both knowing when to file the 982 and also the reduction of tax attributes.

DJ in your post above "The basis in their residence should remain unchanged, yes?" Are you assuming in your example that no other debt was forgiven?

I used to be less concerned about reducing basis in a primary residence but Dave has pointed out that the nature of the adjustment is similar to depreciation in that it would trigger taxable income if there is a gain and this cannot be avoided with a 121 exclusion. (Dave please correct me if I am not quoting you correctly.)

Thanks again for pointing me in the right direction.

DJCCPA (talk|edits) said:

15 June 2011
No, I'm assuming that all other debt is included (credit cards, medical, etc.) In fact, that's one of the legal parameters of filing bankruptcy. You can't pick and choose debt to include such as, "well, I owe $5K to AMEX so let's include that but only $10 on my Kohl's card so I'll pay that off myself and try to keep that credit line open." Everything goes on the filing.

DJCCPA (talk|edits) said:

15 June 2011
but you should find out how they're handling the mortgage on the home. Whether they're simply paying the mortgage outside of the plan/reaffirming vs. "riding through", etc.

EZTAX (talk|edits) said:

15 June 2011
DJ - I guess I am confused. If other debt is being cancelled, then when the debt is "officialy" cancelled (either by court order in the beginning of the process or at the end of the process) then you would have to reduce the basis in the home by the COD unless other attributes exist.

DJCCPA (talk|edits) said:

15 June 2011
Think about it like this (and I'm not being snarky, I swear).

Why would unsecured debt that is completely unrelated to the asset (home) affect the asset's basis?

EZTAX (talk|edits) said:

15 June 2011
Because COD, even from bankruptcy, requires form 982 to be filed and a reduction of tax attributes. There is a "pecking order" but if the there are no NOL or Capital loss carryforwards, and the taxpayer has assets, then my understanding is that the basis in the assets gets reduced.

I believe that this is what Dave is saying in his above post - he has a great deal of experience in this area and has been very helpful in posting on the subject.

EZTAX (talk|edits) said:

15 June 2011
Oh, you did not at all sound "snarky" but I appreciate your sensitivity regarding the possiblity :).

DJCCPA (talk|edits) said:

16 June 2011
About 9 posts up - check my question to Dave regarding the basis of the principal residence remaining unchanged.

DaveFogel (talk|edits) said:

16 June 2011
Just to clarify my answer above, if --
  • the client has ANY debt discharged in a Chapter 13 bankruptcy before the end of the 5-year period (including unsecured debt);
  • the Chapter 13 plan is designed to pay off other debts;
  • the client has no NOL carryovers, general business credit carryovers, minimum tax credit carryovers, or capital loss carryovers; and
  • the client is allowed to keep his or her principal residence;

then the client will have to reduce the basis of the principal residence by the amount of COD income excluded under the bankruptcy exclusion. The debt discharged in bankruptcy doesn't have to be the debt secured by the residence for this rule to apply. As EZTAX points out, it can be ANY debt that's discharged in bankruptcy.

EZTAX (talk|edits) said:

17 June 2011
Thanks for clearing that up Dave.

I believe you have said in the past that if the primary residence is sold at a gain, then the amount of the gain created by the COD basis reduction will be taxable and cannot be avoided by 121. Is this understanding correct?

DaveFogel (talk|edits) said:

17 June 2011
I don't know if I've addressed this issue in the past.

If the taxpayer reduces the basis of the principal residence by the COD income excluded under the bankruptcy or insolvency provisions of Sec. 108, then under Sec. 1017(d), the basis reduction is treated as depreciation allowed under Sec. 1245. Under Sec. 121(d)(6), the home sale exclusion doesn't apply to any portion of the gain that's attributable to depreciation (as defined in Sec. 1250(b)(3)) for periods after May 6, 1997.

Since the basis reduction is treated as depreciation allowed under Sec. 1245, and since Sec. 121(d)(6) precludes the exclusion of gain for depreciation taken under Sec. 1250 (i.e., a different Code section), I don't know whether the portion of gain that's allocable to the basis reduction is eligible for the Sec. 121 exclusion.

Anybody else have ideas?

RoyDaleOne (talk|edits) said:

17 June 2011
http://cclawyer.cccba.org/2011/06/the-dark-side-of-debt-forgiveness/

DAJCPA (talk|edits) said:

17 June 2011
The question originally posted here has been reposted in a new discussion: Discussion:COD & Tax Attribute Reduction-1017(b)(2) basis reduction in non-exempt property resulting from basis in exempt property (removing the post that was here to avoid having a duplicate discussion arise; see FAQ 21 for why.

ZL28 (talk|edits) said:

17 June 2011
I spoke with IRS and I realize there are limits to that, but rep said if bankruptcy, as affirmed by Roy Dale One's article, that principal

residence's basis in not reduced on line 10a with a ch 7 or 13. She did mention line 10b would be where reduce basis in principal residence, but that only corresponds with qualified prinipal residence idnebtedness

Royal's article mentioned basis in exempt assets does not get reduced under Ch 7...can anyone provide a link or explanation as to

what comprises 'exempt assets'

DaveFogel (talk|edits) said:

17 June 2011
See Sec. 1017(c)(1), which cites 11 U.S.C. §522.

EZTAX (talk|edits) said:

17 June 2011
Wow - thanks everyone. Just when you think you are close to understanding this stuff.....

Hope everyone has a great weekend and am looking forward to continuing this discussion.

EZTAX (talk|edits) said:

20 June 2011
This has been a great discussion. I had not realized that COD rules and tax attribute reduction rules were different if taxpayer goes through bankruptcy.

Anyone else have thoughts/ideas on if taxpayer is not going through bankruptcy, and primary resident home's basis is reduced due to COD/insolvency rules, can we exclude the gain caused by the basis reduction using 121? Thanks.

ZL28 (talk|edits) said:

21 June 2011
If there is no bankrputcy estate - 1041 - set up for an individual going Ch 7, does that indivual

still have to reduce attributes?

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