What is income? This question has persisted from the inception of the federal income tax code. Courts have defined income as “an accession to wealth, by any means whatever.” Section 61 of the income tax code provides many examples of income, including wages, salary, and commissions. It also references something called “discharge of indebtedness.” This concept has taken on many other names, including “cancellation of debt,” “debt forgiveness,” and even “phantom income.”
A simple example should suffice: Sam loans Bill $1000. Bill has a difficult time paying Sam back and is only able to return small amounts of the loan on an irregular basis. Rather than accept $10 every other week, Sam decides to “write off” the loan. This allows Sam to take a $1000 bad debt deduction. This also results in Bill realizing $1000 in income. If Sam were a financial institution, he would send Bill a form 1099 – C entitled “cancellation of debt.” This would cause Bill to include the $1000 as income on his tax return.
In this example, Bill actually received $1000 from Sam. Theoretically, he could set aside $250 of that amount to pay his income tax obligations. But what happens when a taxpayer does not receive any money whatsoever? This happens routinely with distressed real estate.
Consider the following scenario: Dan has a steady job and decides to purchase his dream home at the peak of the real estate market. He purchased his home with an interest-only $400,000 mortgage. After two years he must begin repaying principal, and his monthly payment mushrooms. He is unable to make the mortgage payments and decides to sell his home. Unfortunately, the fair market value of his home is now $200,000. Meanwhile, his obligation to the lending institution has increased by the total of all of his missed payments, interest and penalties. He now owes $425,000. He moves out of the house into an inexpensive apartment and places his dream home on the market. His real estate agent contacts a buyer of distressed properties who is willing to pay $200,000 in cash for the home. Dan contacts as lender who is willing to accept the deal and release Dan from any obligations under the note and mortgage. In January, Dan receives a 1099 – C from his lender indicating that he is received $225,000 in income. If Dan is in the 20% income tax bracket, he will owe the IRS $45,000.
Because of situations like this, Congress passed a statute exempting income from the cancellation of debt involving a principal residence. Unfortunately, Dan moved out of the home. Does it still qualify as his principal residence for income tax purposes? It depends upon all of the facts and circumstances surrounding Dan’s living arrangements. Dan would be well advised to seek the advice of a tax expert in this situation.
But let’s assume that the home does not qualify as Dan’s principal residence. Can he avoid his $45,000 tax liability? The answer is a qualified “yes,” but it requires advance planning. In other words, Dan should anticipate the realization of this income and take steps in an effort to avoid the tax obligation. Basically, Dan must plan to be “insolvent” at the time the debt is canceled. When is the debt canceled? Again, the answer depends on all of the facts and circumstances surrounding the sale of the home and the actions of the lender. A tax expert can assist Dan in meeting one or more of the exemptions available under the tax law.
December 25, 2011 at 9:14 am
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