Discharge of Debt Income is culled from the NEW 4th Edition of The Tool & Techniques of Income Tax Planning. It covers: When Can a Discharge of Debt Be Excluded from Gross Income?; Types of Indebtedness; Recourse v. Nonrecourse; Which Types of Debt Can Be Excluded from a Taxpayer’s Gross Income?; Which Types of Debt Can Be Excluded from a Taxpayer’s Gross Income?; and MORE.

1. Learn more, by going to www.NationalUnderwriter.com/IncomeTax
DISCHARGE OF DEBT INCOME
(from the NEW edition of The Tools & Techniques of Income Tax Planning)
What You’ll Find Inside:
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When Can a Discharge of Debt Be Excluded from Gross Income?
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Types of Indebtedness
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Recourse v. Nonrecourse
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Which Types of Debt Can Be Excluded from a Taxpayer’s Gross Income?
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Which Types of Debt Can Be Excluded from a Taxpayer’s Gross Income?
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AND MORE
The National Underwriter Company
Presents...
THE TOOLS & TECHNIQUES OF INCOME TAX PLANNING, 4TH EDITION
This single-volume reference takes you through all the income tax topics your clients may encounter, no matter where they originate, providing easy-to-understand, practical guidance for situations that are often confusing.

2. Income Tax PlannIng366date, Gary’s employer forgives the loan. In this case, unlike a borrower and a conventional lender, Gary and his boss have an employee- employer relationship. For this reason, rather than characterize the forgiven debt as section 61(a)(12) income, it is treated as compensation income under Code section 61(a)(1).6We can think of the example above as if Gary’s employer had actually paid him $10,000 in compensa- tion that he in turn used to repay the loan. Obviously, if that had occurred, there would be no discharge because the loan would have been paid in full. The only differ- ence between the two scenarios is whether any money changed hands. For tax purposes, regardless of how the transaction is structured, the employee is deemed to have received taxable wages and not discharge of debt income because of his employment relationship with the “lender.”7In addition to a pure debtor-creditor relationship between the parties, sections 61(a)(12) requires that the debt be discharged for no consideration. If the debt is satisfied by the transfer of money or some other valuable good, the transaction is not considered a discharge of the debt, and is not included as section 61(a)(12) income. Example: Patty Portrait borrows $10,000 from Gene Gallery. When the loan becomes due, Patty lacks the funds to pay it. In lieu of pay- ment, Gene agrees to accept a painting Patty purchased several years ago for $5,000, which is now worth $10,000. Although Patty and Gene have a pure debtor-creditor relationship, Patty is essentially selling the painting to Gene for an amount equal to the outstanding debt. In the alternative, Gene could purchase the painting from Patty for $10,000 that she in turn could pay to Gene to satisfy the loan. Similar to the previous example, even though no money actually changed hands, there is no forgiven debt. Instead, the transaction is treated as a sale of the painting. Patty’s income (likely capital gain) is the difference between the fair market value of the painting—$10,000, which also happens to be the loan balance—and her basis of $5,000. Here, Patty realizes a $5,000 gain that is included in gross income under Code section 61(a)(3), rather than section 61(a)(12).8WHEN CAN A DISCHARGE OF DEBT BE EXCLUDED FROM GROSS INCOME? Sometimes items that are normally included in gross income are nonetheless excluded by a specific section of the Code. Such is the case with respect to section 61(a)(12) discharge of debt income. Under certain cir- cumstances, Code section 108 excludes a discharge of debt from a taxpayer’s gross income. The exclusion can apply to any type of liability, including loans, lines of credit, and credit card debt. The discharge can occur as the result of a creditor write-off, foreclosure, short sale, deed in lieu of foreclosure, or abandonment. However, this exclusion only applies to a discharge of debt that is otherwise required to be included in gross income under section 61(a)(12). Types of IndebtednessThere are two important—and related—ways to categorize any debt. First, all debt is either “secured” or “unsecured.” The second distinction is between “recourse” versus “nonrecourse” indebtedness. Secured versus UnsecuredDebt is “secured” if the borrower pledges specific property as collateral against the loan. As a hedge against a potential default, many lenders insist on secur- ing a loan with specific property owned by the borrower that is pledged as collateral. By doing so, payment of a defaulted loan is assured to the extent of the value of the secured property. Common types of secured loans include home mortgages and car loans. If the borrower fails to repay the loan according to schedule, the lender may take possession of the collateral (the house or the car) and use the proceeds from its sale to repay the loan. If no collateral is offered, then the loan is “unsecured.” Recourse versus NonrecourseIn a “recourse” debt, the borrower’s obligation to repay a recourse debt is unconditional. This means that in the event of default, the lender may legally pursue collection against not only the assets purchased by borrowed money but all of the borrower’s assets, even if the loan is secured by collateral.9 Recourse debt may be either secured or unsecured, depending on whether

3. Income Tax PlannIng366date, Gary’s employer forgives the loan. In this case, unlike a borrower and a conventional lender, Gary and his boss have an employee- employer relationship. For this reason, rather than characterize the forgiven debt as section 61(a)(12) income, it is treated as compensation income under Code section 61(a)(1).6We can think of the example above as if Gary’s employer had actually paid him $10,000 in compensa- tion that he in turn used to repay the loan. Obviously, if that had occurred, there would be no discharge because the loan would have been paid in full. The only differ- ence between the two scenarios is whether any money changed hands. For tax purposes, regardless of how the transaction is structured, the employee is deemed to have received taxable wages and not discharge of debt income because of his employment relationship with the “lender.”7In addition to a pure debtor-creditor relationship between the parties, sections 61(a)(12) requires that the debt be discharged for no consideration. If the debt is satisfied by the transfer of money or some other valuable good, the transaction is not considered a discharge of the debt, and is not included as section 61(a)(12) income. Example: Patty Portrait borrows $10,000 from Gene Gallery. When the loan becomes due, Patty lacks the funds to pay it. In lieu of pay- ment, Gene agrees to accept a painting Patty purchased several years ago for $5,000, which is now worth $10,000. Although Patty and Gene have a pure debtor-creditor relationship, Patty is essentially selling the painting to Gene for an amount equal to the outstanding debt. In the alternative, Gene could purchase the painting from Patty for $10,000 that she in turn could pay to Gene to satisfy the loan. Similar to the previous example, even though no money actually changed hands, there is no forgiven debt. Instead, the transaction is treated as a sale of the painting. Patty’s income (likely capital gain) is the difference between the fair market value of the painting—$10,000, which also happens to be the loan balance—and her basis of $5,000. Here, Patty realizes a $5,000 gain that is included in gross income under Code section 61(a)(3), rather than section 61(a)(12).8WHEN CAN A DISCHARGE OF DEBT BE EXCLUDED FROM GROSS INCOME? Sometimes items that are normally included in gross income are nonetheless excluded by a specific section of the Code. Such is the case with respect to section 61(a)(12) discharge of debt income. Under certain cir- cumstances, Code section 108 excludes a discharge of debt from a taxpayer’s gross income. The exclusion can apply to any type of liability, including loans, lines of credit, and credit card debt. The discharge can occur as the result of a creditor write-off, foreclosure, short sale, deed in lieu of foreclosure, or abandonment. However, this exclusion only applies to a discharge of debt that is otherwise required to be included in gross income under section 61(a)(12). Types of IndebtednessThere are two important—and related—ways to categorize any debt. First, all debt is either “secured” or “unsecured.” The second distinction is between “recourse” versus “nonrecourse” indebtedness. Secured versus UnsecuredDebt is “secured” if the borrower pledges specific property as collateral against the loan. As a hedge against a potential default, many lenders insist on secur- ing a loan with specific property owned by the borrower that is pledged as collateral. By doing so, payment of a defaulted loan is assured to the extent of the value of the secured property. Common types of secured loans include home mortgages and car loans. If the borrower fails to repay the loan according to schedule, the lender may take possession of the collateral (the house or the car) and use the proceeds from its sale to repay the loan. If no collateral is offered, then the loan is “unsecured.” Recourse versus NonrecourseIn a “recourse” debt, the borrower’s obligation to repay a recourse debt is unconditional. This means that in the event of default, the lender may legally pursue collection against not only the assets purchased by borrowed money but all of the borrower’s assets, even if the loan is secured by collateral.9 Recourse debt may be either secured or unsecured, depending on whether

4. Income Tax PlannIng368portion of the payments toward a debt (e.g. interest payments on a business loan), then the discharged debt will not be included in the taxpayer’s gross income. This exclusion only applies to the amount of the debt that would have been tax deductible had it been paid.17 This type of discharge still carries consequences for the taxpayer’s gross income: rather than being included as income, the discharge means that the taxpayer will not enjoy the benefit of the deduction. 8. Discharge of purchase money debt: “Purchase money debt” is money that is lent by a seller to a buyer to facilitate a purchase. The code treats a discharge of this type of debt as a reduction in the purchase price, and it is therefore excluded from the buyer/borrower’s gross income. This exclusion applies even when the buyer is not in bankruptcy or insolvent.18In many instances, it is possible that the discharge of debt may qualify for more than one category of exclu- sion under section 108. For example, a debtor who files bankruptcy may also be insolvent. If a discharge of debt qualifies for more than one of the section 108 exclusion categories, Figure 32.1 sets forth which of the exclusions would take precedence.19The following example contains a step-by-step analy- sis of whether and to what extent a discharge of debt section 61(a)(12) would be excluded from gross income under section 108. Example: Molly Cule, a sole proprietor, takes out $100,000 in recourse debt from First Bank to fund working capital in her business. A year later when the loan becomes due, Molly de- faults. Although Molly owns attachable assets, First Bank forgives the loan without pursuing a legal collection action against her. At the time of the discharge the amount of Molly’s liabilities are $140,000 (including the $100,000 loan), and the fair market value of Molly’s single asset— a construction crane used in her business—is $90,000. Thus, prior to the discharge, Molly is insolvent with a negative net worth of $50,000— the amount by which her liabilities ($140,000) exceeds the fair market value of her cumulative assets ($90,000). Step 1 – Is there section 61(a)(12) discharge of debt income? Recall that section 108 exclusions only apply to discharges of debt that would otherwise be considered gross income under Code section 61(a)(12). Here, Molly’s discharge meets the section 61(a)(12) requirements because: 1. Molly and First Bank have a pure debtor- creditor relationship; and2. First Bank forgave a legally enforceable debt for no consideration. Thus, Molly has $100,000 of discharge of debt income tentatively included in gross income under section 61(a)(12). Figure 32.1If a discharge of debt qualifies for all the following section 108(a)(1) exclusions: The exclusion that takes precedence is: • Bankruptcy exclusion• Insolvency exclusion• Qualified farm indebtedness exclusion• Qualified real property business indebtedness exclusion• Qualified principal residence indebtedness exclusionBankruptcy exclusion• Insolvency exclusion• Qualified farm indebtedness exclusion• Qualified real property business indebtedness exclusionInsolvency exclusion• Insolvency exclusion• Qualified principal residence indebtedness exclusionQualified principal residence indebtedness exclusionBK-

5. DISCHARGE OF DEBT INCOME CHApTER 32369Step 2 – Is the discharged debt considered “indebted- ness of the taxpayer?” Molly’s loan is not secured by her property, but it is a recourse loan. Upon her default, First Bank decided to forgive the $100,000 loan balance rather than pursue a legal collection action against Molly to attach her assets. Because the bank could have pursued all of Molly’s as- sets, the $100,000 discharged loan meets the first requirement of section 108 by being a recourse loan. Step 3 – Does the discharge fall into one of the exclusion categories found in section 108? Recall that immediately before the discharge Molly was insolvent to the extent of $50,000. Thus, the insolvency exclusion applies to Molly’s $100,000 loan discharge. Also, though Molly was insolvent at the time of discharge, there is no indication that the discharge occurred pursuant to a bankruptcy, and none of the other section 108(a)(1) exclusions are applicable. Thus, the only exclusion applicable is the insolvency exclusion. Step 4 – How much of the discharged debt is ex- cluded from gross income under the applicable section 108 exclusion? Not all of the section 108 exclusions exclude the entire discharge of debt from gross income. Here, the insolvency exclusion is limited to the extent the taxpayer was insolvent prior to the discharge. Prior to the discharge Molly was insolvent by $50,000. After the $100,000 discharge, however, Molly became solvent by $50,000 ($90,000 asset minus the remaining liabilities of $40,000). Thus, Molly’s insolvency exclusion is limited to $50,000 of the $100,000 in discharged debt— the amount by which she was insolvent prior to the discharge. The remaining $50,000 of dis- charged debt made her solvent and increased her net worth from zero to $50,000. After applying the insolvency exclusion, Molly would include $50,000 in gross income under section 61(a)(12) from the discharge of the First Bank loan. DISCHARGES OF DEBT IN FORECLOSURE-TYpE TRANSACTIONSBy their very nature, foreclosures, short sales, and deeds in lieu of foreclosure (collectively known as “foreclosure-type transactions”) often involve discharges of debt. The question is whether the discharge qualifies as gross income under section 61(a)(12) and is therefore potentially excludible under section 108. The answer to this question depends greatly on whether the discharged debt was recourse or nonrecourse. Most of this section will discuss discharges of debt in foreclosure-type trans- actions under the assumption that the discharge applies to recourse debt. The rules for nonrecourse debt in fore- closure transactions are more complicated, and will be discussed separately. At the outset, it is important to note that the Code treats foreclosures,20 short sales, and deeds in lieu of foreclosure21 as sales for tax purposes. This treatment means that in addition to potentially reporting income from a discharge of debt, a taxpayer must also calculate the gain or loss from the sale. If the sale price of the underlying property is equal to or greater than the taxpayer’s cost basis, the difference between the sale price and the taxpayer’s cost basis for the property is considered “gain” on the sale of property (even though the taxpayer may not actually see any of that money), and is included in gross income under Code section 61(a)(3), rather than section 61(a)(12). Recall that section 108 exclusions are only available for discharges of debt income that fall under section 61(a)(12). Accordingly, the amount of discharge of debt income that falls under section 61(a)(12)—and is therefore potentially excludable under section 108—is limited to the amount by which the debt on the property that is forgiven exceeds the sale price. It is also possible for the sale price to be less than the taxpayer’s cost basis in the property. In that case, the difference between the sale price and basis is realized as a loss under Code section 165. When realizing a loss on the sale of the property, the discharge of debt income is still limited to the amount by which the balance of the loan exceeds the sale price of the property. An important issue that often arises in foreclosure- type transactions is that a discharge of the debt is not guaranteed. If the sale price of the underlying property is less than the amount of discharged debt, the creditor can either pursue a legal collection action against the debtor to satisfy the remaining balance of the debt, or simply forgive the remaining balance of the debt. The treatment of this remaining balance varies according to state law, and is often subject to the lender’s discretion or an agreement that the borrower may have reached with the lender prior to the sale. Sometimes the debt left over after the sale is forgiven. But in other instances, the lender will continue to pursue the borrower (and all of his or her legal assets) for the balance of the loan.