2020 NATIONAL INCOME TAX WORKBOOK CHAPTER 1 FINANCIAL

2020 NATIONAL INCOME TAX WORKBOOK CHAPTER 1: FINANCIAL DISTRESS

CHAPTER 1: FINANCIAL DISTRESS • Foreclosures and Repossessions • Cancellation-of-Debt Income • Abandonments • Debt-Related Information Returns • Bad-Debt Deduction • 2020 Relief Loans and Grants

FORECLOSURES P. 2 Treated as a sale Borrower has gain or loss Difference between amount realized and adjusted basis

NONBUSINESS FORECLOSURES P. 2 Recourse loan (personally liable) Amount realized is smaller of 1. the outstanding debt immediately before the transfer reduced by any amount taxpayer is personally liable for immediately after the transfer OR 2. the FMV of the transferred property Community Bank v. Commissioner Sale price of property at foreclosure presumed to be FMV

EXAMPLE 1. 1 2015 Lorna bought land $100, 000 to build primary residence $ 20, 000 down and financed $80, 000 Personally liable and land secured loan 2020 loan balance $65, 000 and FMV of land $110, 000 Foreclosure – bank sold land for $110, 000 and applied to balance owed Lorna received $45, 000 (excess from sale) ◦ $110, 000 amount realized ($65, 000 loan balance + $45, 000 proceeds) ◦ $10, 000 gain ($110, 000 amount realized - $100, 000 adjusted basis) P. 2

EXAMPLE 1. 2 PP. 2 -3 FMV of Lorna’s land declined to $60, 000 Foreclosure - bank sold land for $60, 000 and forgave the $ 5, 000 ◦ Lorna has $5, 000 cancellation-of-debt income ◦ Lorna has $40, 000 loss ($60, 000 amount realized on the sale – $100, 000 basis) PERSONAL USE ASSET - NO DEDUCTION

FIGURE 1. 1 P. 3

NONBUSINESS FORECLOSURES Nonrecourse loan – not personally liable Amount realized = amount of debt Repossession satisfies debt – no COD income Example 1. 3 – nonrecourse loan Amount realized is $65, 000 loan balance $35, 000 nondeductible loss P. 3

BUSINESS PROPERTY FORECLOSURES Capital gain or loss OR Ordinary income or loss Gain included in income Loss may be deductible P. 4

CANCELLATION-OF-DEBT INCOME P. 4 Forgiven loan included in income (unless exclusion) COD income = diff. between amount of debt and amount accepted (including FMV of property) in satisfaction of the debt

EXAMPLE 1. 4 PP. 4 -5 2018 Donald borrowed $20, 000 to buy $23, 000 personal truck 2020 bank repossessed the truck $12, 000 FMV and $15, 000 loan balance Sold truck for $12, 000 and discharged $3, 000 $11, 000 nondeductible loss ($12, 000 FMV - $23, 000 basis) $3, 000 COD income ($15, 000 loan balance - $12, 000 FMV)

COD INCOME – EXCEPTIONS P. 5 Gift Deductible debt [I. R. C. § 108(e)(2)] ◦ Example 1. 5 Lost Deduction – mortgage interest Purchase price reduction ◦ Example 1. 6 Price Reduction – seller reduced b/c home inspection issues

COD EXCLUSIONS – BANKRUPTCY PP. 5 -6 Debtor under court jurisdiction Cancellation by the court ordered plan Taxpayer must be the debtor

COD EXCLUSIONS – INSOLVENCY P. 6 Liabilities exceed assets immediately before discharge Use Pub. 4681 Insolvency Worksheet (Fig. 1. 2) to calculate Exclusion limited to amount of insolvency

LIMITATION ON INSOLVENCY EXCLUSION Example 1. 7 Gary relieved of $5, 000 personal credit card debt Liabilities = $10, 000 FMV of assets = $7, 000 Insolvency amount = $3, 000 ($10, 000 – $7, 000) Excluded COD income = $3, 000 Recognized COD income = $2, 000 P. 7

COD EXCLUSIONS – QUALIFIED FARM DEBT P. 7 § Owed to a qualified person – actively and regularly lends money § Incurred directly in the taxpayer’s trade or business of farming - at least 50% of aggregate gross receipts for 3 prior years from farming §PN P. 8 – farm COD income is subject to SE tax

QUALIFIED FARM DEBT EXCLUSION – LIMITATION P. 7 Excluded cancelled farm debt cannot be more than the sum of: 1. Taxpayer’s adjusted tax attributes AND 2. the total adjusted basis of qualified property the taxpayer held at the beginning of the tax year following the year of the discharge

COD EXCLUSIONS – QUALIFIED REAL PROP. BUS. DEBT P. 8 QRPBI is ◦ Not qualified farm debt ◦ Incurred to acquire, construct, reconstruct, or substantially improve real property used in trade or business (and refinancing) ◦ Secured by real property ◦ DEPRECIABLE RENTAL PROPERTY may qualify ◦ Limitations on exclusion ◦ PN P. 9 ELECTION REQUIRED – Form 982

COD EXCLUSIONS – QUALIFIED PRINC. RESIDENCE DEBT P. 9 QPRI is Mortgage to buy, build, substantially improve main home (and refinancing of that mortgage. Secured by the main home PN - CHECK STATE LAW – exclusions MAY be different Limited to $2 M ($1 M MFS) Extended through 2020

ORDERING RULES FOR COD EXCLUSIONS 1. Bankruptcy 2. Qualified principal residence debt 3. Insolvency 4. Qualified farm debt 5. Qualified real property business debt Taxpayer can elect #3 instead of #2 P. 9

REDUCTION IN TAX ATTRIBUTES P. 9 o COD exclusion only DEFERS tax o Generally, tax attributes reduced by excluded amount o File Form 982 FIGURE 1. 3 (P. 10) Tax Attribute Reduction Rules

REDUCING TAX ATTRIBUTES – QPRI 11 PP. 10 - REDUCE BASIS IN RESIDENCE BY EXCLUDED AMOUNT Ex. 1. 8 2015 Sloan purchased principal residence for $600, 000 Loan modification and $50, 000 discharge Excludes $50, 000 QPRI $50, 000 basis adjustment for QPRI 2021 Sells home for $700, 000 Gain = $150, 000 ($700, 000 – $550, 000) – Section 121 exclusion?

REDUCING ATTRIBUTES – BANKRUPTCY & INSOLVENCY P. 11 COD income exclusions for bankruptcy/insolvency reduce 7 tax attributes: ◦ NOL, general business credit, minimum tax credit, capital loss carryovers, basis (see ordering rules), PAL carryovers and credit carryovers, foreign tax credit carryovers If taxpayer only has personal property, reduce basis in personal property (with some limitations)

ELECTING BASIS REDUCTION P. 11 Ordering rules for reducing tax attributes b/c of bankruptcy or insolvency exclusion Taxpayer can elect to first reduce basis of depreciable assets before reducing other attributes

ATTRIBUTE REDUCTION – INSOLVENCY Example 1. 9 – General ordering rules Doug defaulted on $5 M operating loan Secured by office building, equipment, 5 parcels held for sale Bank forgave $1 M Insolvency exclusion applies Doug must reduce tax attributes NOL Basis in office building and land Basis in equipment Basis in real estate held for sale SEE FIGURES 1. 5 and 1. 6 PP. 12 -14

ATTRIBUTE REDUCTION – INSOLVENCY CONT. Example 1. 10 – Elected ordering rules Doug wants to save his NOL Elects to reduce basis in depreciable property first Elects to treat property held for sale as depreciable property SEE FIGURES 1. 7 and 1. 8 PP. 14 -16

BASIS REDUCTION LIMITS - BANKRUPTCY/INSOLVENCY -17 PP. 16 Limits on basis reduction of personal use property Limits don’t apply if elect to reduce basis of depreciable property first Calculate the total limit, then proportionately reduce Ex. 1. 11 Elaine $1, 500 debt forgiveness, insolvent Basis reduction limit is $100 applied proportionately to furniture and jewelry

REDUCING ATTRIBUTES – FARM DEBT/BUSINESS DEBT EXCLUSIONS P. 17 Farm debt exclusion - tax attributes reduce same as bankruptcy/insolvency EXCEPT Only basis of qualified property is reduced ◦ FIRST depreciable qualified property ◦ SECOND land held or used in farming ◦ THIRD other qualified property Qualified real property business debt exclusion - reduce only basis of depreciable real property

CANCELLED DEBT – REPAYMENT Include COD income in income Later repay Claim for refund not a deduction IRS advice – not precedent P. 17

GAIN ON TRANSFER/COD INCOME PP. 17 -18 Property transferred and debt cancelled – gain and COD income Example 1. 12 Deed in Lieu of Foreclosure Dmitri had a $500, 000 recourse business loan secured by office building with $350 K basis and $400 K FMV Deed in lieu of foreclosure and the bank cancelled the loan $50, 000 (FMV – basis) gain and $100, 000 (discharged debt – FMV) COD income If instead nonrecourse $150, 000 gain and $0 COD income

ABANDONMENTS P. 18 Voluntarily and permanently gives up possession and use Property securing recourse debt – no gain or loss until foreclosure is complete Example 1. 13 Juanita had a 200 K recourse loan to purchase a house In 2020 loan balance was $185, 000 and FMV $150, 000 Juanita moves out and mails the keys to the lender No foreclosure in 2020 – no gain or loss

ABANDONMENTS CONT. P. 19 Nonrecourse debt – abandonment is sale or exchange and amount realized is the amount of the nonrecourse debt Example 1. 14 Juanita’s debt was nonrecourse. When she abandoned the home, she had a $15, 000 loss ($185, 000 mortgage balance - $200, 000 basis) NONDEDUCTIBLE B/C PERSONAL ASSET Example 1. 15 Robert abandons business property secured by nonrecourse business debt. He has a deductible loss.

DEBT RELATED INFORMATION RETURNS 20 PP. 19 - 1099 -A abandonments/acquisitions (Figure 1. 10) 1099 -C cancellation of debt If debt is cancelled and property is abandoned/acquired in the same year – only issue Form 1099 -C

CANCELED DEBT - IDENTIFIABLE EVENTS -21 PP. 20 Debt is deemed canceled on identifiable even or (if earlier) actual discharge. Identifiable events are §A discharge of indebtedness under Bankruptcy Code §Debt becomes unenforceable in a receivership, foreclosure, or similar proceeding in a federal or state court §Expiration of statute of limitations for collections §Election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor’s right to pursue collections §Probate or similar proceeding that render a debt unenforceable §Lender and debtor agree to discharge §Lender’s decision or policy to not collect

FORECLOSURE REPORTING Example 1. 16 Don owns a snowboard shop $100, 000 recourse loan secured by shop 2020 foreclosure FMV = $75, 000 Loan balance = $80, 000 Bank sale = $75, 000 discharged = $5, 000 Bank issues 1099 -C – Figure 1. 11 P. 21

INFORMATION REPORTING P. 22 Cozzi v. Commissioner, debt canceled/discharged based on facts & circumstances Owens v. Commissioner, issuance of Form 1099 -C is not dispositive of an intent to cancel debt Parker v. Commissioner, IRS has no duty to investigate third party payment report that is not disputed Portillo v. Commissioner, if taxpayer reports different amount than reported on 1099 -C, IRS must show information report is correct 1099 -C income may not have to be included if taxpayer paid the debt later Taxpayer may have COD income and no 1099 -C

BAD DEBT DEDUCTION P. 23 Worthless debt BUSINESS BAD DEBT – may claim deduction NONBUSINESS BAD DEBT – may claim short-term capital loss Business bad debts are Debts that were created or acquired in the taxpayer’s trade or business OR Debts that were related to taxpayer’s trade or business at the time they become worthless

BUSINESS BAD DEBTS PP. 23 -24 Created in business – Ex. 1. 17 Allen extends credit to Brian then Allen sells the business and retains the claim against Brian Related to business – Ex. 1. 18 Allen did not retain the claim against Brian and the new owner has a business bad debt Unrelated to business – Ex. 1. 19 Allen instead sells the debt to Denise does not have a business bad debt Debt acquire from decedent – Ex. 1. 20 Allen died and left the business to his son. His son has a business bad debt

BONA FIDE DEBT P. 24 Debtor-creditor relationship Enforceable obligation to pay Included in receivables of accrual method taxpayer BAD DEBT Cash method taxpayers - unpaid wages, compensation, rent NOT BAD DEBT Types of business bad debts: ◦ Loans ◦ Credit sales ◦ Business loan guarantees

BUSINESS LOANS P. 24 Loan or capital contribution – Dixie Dairies factors Ex. 1. 21 Loan to supplier Sam relies on his supplier for parts. He loans money to the supplier. The loan is a business debt.

CREDIT SALES P. 25 Sell good on credit Perform services for promise of future payment Ex. 1. 22 Cash method taxpayer Priya performs services but never gets paid. No baddebt deduction Ex. 1. 23 Accrual method taxpayer Priya includes the service income when the services are performed. Bad-debt deduction when debt becomes worthless

BUSINESS LOAN GUARANTEES P. 25 1. Taxpayer makes the guarantee in course of trade or business 2. Taxpayer has a legal duty to pay the debt 3. Guarantee made before the debt became worthless 4. Reasonable consideration for making the guarantee Ex. 1. 24 Loretta sells her clothing line at a dress shop. Loretta guaranteed a loan to the shop so it would stay in business and continue to sell her clothing. The dress shop defaulted, and Loretta’s company paid. Loretta can claim a business bad-debt deduction.

TOTALLY WORTHLESS DEBT 26 -27 PP. NO CHANCE IT WILL BE PAID ◦ Reasonable steps to collect ◦ Judgment from a court would be uncollectible TWO METHODS TO CLAIM 1. Specific charge-off method 2. Nonaccrual experience method REPORTING Example 1. 24 Sam is a sole proprietor and reports the deduction on Schedule C (Form 1040) FIGURE 1. 12

NONBUSINESS BAD DEBTS P. 28 Debts other than business debts Ex. 1. 25 gift to child with no obligation to repay is not a nonbusiness debt Ex. 1. 26 Loan to son with note and obligation to pay is a nonbusiness debt Ex. 1. 27 Deposit for kitchen cabinets is a nonbusiness debt

NONBUSINESS BAD DEBTS CONT. 30 PP. 28 - Must be totally worthless (not partially) Bad-debt deduction limited to basis in the debt included in income or loaned cash Ex. 1. 28 Nora worked in a flower shop that went bankrupt and didn’t pay her. She did not include unpaid wages in income and cannot claim a bad -debt deduction. REPORT AS SHORT-TERM CAPITAL LOSS ON FORM 8949 – Figures 1. 13 and 1. 14

2020 RELIEF LOANS AND GRANTS P. 31 ECONOMIC INJURY DISASTER LOAN (EIDL) Must be repaid – not included in taxable income EIDL ADVANCE PPP Does not have to be repaid – likely included in taxable income but impacts forgiveness of PAYCHECK PROTECION PROGRAM (PPP) Forgiven loans not included in gross income, but taxpayers cannot deduct payment of expenses that result in loan forgiveness EIDL advance is deducted from amount eligible forgiveness

QUESTIONS?