Michigan Tax Law

Archive for March, 2010

General Rule

In 2009 financial institutions wrote-off $200 Billion in consumer mortgages, and wrote-off $33 Billion in other consumer debt. Cancellation of Debt normally produces taxable income for the debtor. (See Section 61(a)(12) of the Internal Revenue Code). If you have had debt forgiven, you may have to pay tax on part of those write-offs.

In order to provide some relief to taxpayers benefitting from Cancellation of Debt (likely people who have suffered financial harm), Congress has created some exclusions to the general rule. If you fit into one of these exclusions, you are generally required to adjust your “tax attributes”–tax benefits, carryovers or future write-offs that you must give up to take advantage of the exclusions.

Most of the following materials are available in IRS Publication 4681, Cancelled Debts, Forclosures, Repossessions, and Abandonments. The Publication is very technically written, This article will hopefully make that publication more understandable. Also note that the current edition of Publication 4681 is dated for the 2008 tax year. When reading its examples remember that the date January 1, 2009 is meant to refer to the year after the Cancellation of Debt.

If you have property that is repossessed or foreclosed in partial satisfaction of your debt, you are treated as if you sold the property, and must compute a gain or loss. If the property is repossessed or foreclosed in full satisfaction of your debt, you may have two transactions to report, first, the income from the cancellation of the debt, and second, the gain or loss on the disposition of the property.

Forms 1099A and 1099C

If an institution cancelled debt which your client owed, or if your client abandoned property to his lender, he will normally receive Form 1099A, Acquisition or Abandonment of Secured Property, or Form 1099C, Cancellation of Debt. Since these transactions normally produce taxable income, Internal Revenue Service will be looking for the amounts shown on these Forms to be reported on his income tax return.

Discounts and Loan Modifications

A discount or loan reduction received from a lender results in Cancellation of Debt income to the extent of the discount or reduction. The income will be taxable, unless it is covered by an exception. Note that a reduction in the interest rate on an outstanding loan, while it may be as much of a concession as a discount, does not produce Cancellation of Debt income.

Business Tax Deferral on Cancellation of Debt Income

Businesses were granted an elective tax deferral applicable to tax years 2009 and 2010. The deferral allows electing businesses to pay tax on Cancellation of Debt income received in 2009 or 2010 to be reported over a five year period beginning in 2014. Businesses that take advantage of this election are not allowed to take advantage of any exclusion otherwise available.

Foreclosures or Repossessions

If you have property that is repossessed or foreclosed in partial satisfaction of your debt, you are treated as if you sold the property, and must compute a gain or loss.

Recourse Debt: If you owned property subject to a recourse debt (a debt on which you are personally liable for repayment) in excess of the property’s Fair Market Value, foreclosure or repossession of the property will result in Cancellation of Debt income if the lender either cannot, or does not seek payment of the deficiency from you. The Cancellation of Debt income is equal to the excess of the amount owed on the property foreclosed or repossessed over the Fair Market Value of the property. The difference between the Fair Market Value which you have given to the lender, and your “basis” in the property (generally your cost, reduced by depreciation you have claimed on your tax returns) is taxed as a sale or disposition. An excess of the Fair Market Value over your basis produces a taxable gain (which may be ordinary or capital gain). If your basis exceeds the Fair Market Value of the property, you have a loss, which will be deductible if the property was a business asset, but not if it was used personally.

Non-Recourse Debt: If you owned property which was subject to a non-recourse debt (a debt on which you are not personally liable for repayment) in excess of the property’s Fair Market Value, foreclosure or repossession of the property does not result in Cancellation of Debt income. The entire non-recourse debt is treated as the amount realized on the disposition of the property, which is compared to your basis to determine gain or loss.

Abandoned Property: If you abandon property which secures a debt on which you are personally liable and the debt is cancelled, you will realize cancelled debt income equal to the entire debt. You may also have a loss on the abandonment, comparing the amount realized on the disposition (zero) with your adjusted basis.

EXCEPTIONS TO THE CANCELLATION OF DEBT RULES

There are several Exceptions to transactions that might at first appear to be taxable Cancellations of Debt.

Exception 1—Gifts

Cancellation of Debt intended as a gift is not Cancellation of Debt income. Mom and dad can forgive their child’s note without income tax effect.

Exception 2—Student Loans

Student loans forgiven in exchange for work in certain professions for specified periods of time are not considered taxable Cancellation of Debt income. The loan must be given by a government or a qualified educational institution. The Cancellation of Debt which is not taxable has no effect on other tax attributes.

Exception 3—Reduction in Deductible Debt

Forgiveness of debt that would be deductible if paid is not considered Cancellation of Debt income. An example would be the forgiveness by a utility of a bill that would be deductible by the business if it were paid. The cancelled debt is not taxable, and the unpaid debt is not deductible.

Exception 4—Price Reduced After Purchase

If a debt incurred in buying property is reduced by the seller, the reduction is not treated as Cancellation of Debt income, but rather as a reduction of the purchase price. The basis or depreciable basis of the property must be reduced.

EXCLUSIONS REQUIRING TAX ATTRIBUTE REDUCTION

Congress created several Exclusions from the general rule that Cancellation of Debt results in the recognition of income. These Exclusions require that certain tax benefits or “attributes” that the taxpayer might otherwise have must be given up or “reduced” to the extent that Cancelled Debt is excluded from tax. The specific rules relating to which tax attributes are given up vary, depending on which Exclusion is being used. This list of attributes which must be reduced relates to Cancellation of Debt income that is not taxed because it was cancelled in bankruptcy. Attributes are reduced in the following order:

• Any Net Operating Loss incurred in or carried to the year of the Cancellation of Debt;
• General Business Credit incurred in or carried to the year of the Cancellation of Debt (credits are reduced at the rate of $1.00 for each $3.00 of cancelled debt);
• Minimum Tax Credit incurred in the year of the Cancellation of Debt, or earlier (again reducing the credit at the rate of $1.00 for each $3.00 of cancelled debt);
• Any Capital Loss from the year of the Cancellation of Debt, or earlier;
• Basis of property owned, first business property and then non-business property;
• Passive Activity Losses that the taxpayer has carried forward;
• Foreign Tax Credit incurred in the year of the Cancellation of Debt, or earlier (again reducing the credit at the rate of $1.00 for each $3.00 of cancelled debt).

The specific tax attributes affected by each Exclusion from the general rule that Cancellation of Debt income results in the recognition of income vary in each Exclusion.

There are two interesting aspects to the Reduction of Tax Attributes. First, if you don’t have sufficient Tax Attributes to absorb the entire cancelled debt on which income tax is forgiven, you are still entitled to use most Exclusions (other than the Qualified Farm Indebtedness Exclusion). Second, all of the Tax Attribute Reductions are made as of January 1 of the YEAR AFTER the Cancellation of Debt. Delaying the reduction of tax attributes until the year after the Cancellation of Debt appears to be a way Congress is trying to reduce the pain of taxpayers’ financial distress. You are allowed to use your tax benefits for the one final year in which you had Cancellation of Debt income.

Exclusion 1—Bankruptcy

There were 1.4 million personal bankruptcies in the United States in 2009.

Debt forgiven or cancelled in bankruptcy, whether Chapter 7, Chapter 13, or any other provision of the Bankruptcy Code, is excluded from being taxed. Publication 4681 uses the unfortunate term “Title 11 Bankruptcy” which might imply that there is some other type of bankruptcy. Title 11 is the entire Bankruptcy Code, so all forms of bankruptcy are included.

When using the Bankruptcy Exclusion, the taxpayer’s tax attributes, as listed above, must be adjusted in the order listed. The taxpayer may, at his option take the entire reduction in tax attributes from his depreciable business property, first from depreciable real property, and then from depreciable personal property. If he has additional untaxed debt, he must then reduce his other tax attributes, if any.

Exclusion 2—Insolvency

Debt forgiven or cancelled is excluded from taxation to the extent that the debtor is insolvent before the cancellation. The Insolvency referred to here is not the inability to pay current debts as they come due, it is the “bankruptcy definition” of insolvency—debts exceeding assets. Thus if a $10,000 debt is cancelled for a person whose debts exceed his assets by $7,000, the Cancellation of Debt income is not taxed to the extent of $7,000. The remaining $3,000 is subject to tax. The assets that are included in the formula for determining the taxpayer’s solvency include his retirement funds.

When using the Insolvency Exclusion, the taxpayer’s tax attributes must be reduced, the same attributes and in the same order as under the Bankruptcy Exclusion.

Exclusion 3—Qualified Farm Indebtedness

Debt forgiven or cancelled is not taxed to the extent that it is Qualified Farm Indebtedness. Qualified Farm Indebtedness is indebtedness incurred directly in connection with the business of farming, by a farmer (over half of whose gross receipts for the three years prior to the cancellation were from farming), which cancellation is by an organization whose business is lending money. It can’t be the farmer’s family, the seller of the farm property, or a person who receives a commission from the farmer’s investment in the property. The farmer cannot exclude more than the adjustments to his “tax attributes”.

If the debt cancelled qualifies for the bankruptcy exclusion, that must be applied first. If the debt qualifies for the insolvency exclusion, that must be applied before the Qualified Farm Indebtedness Exclusion.

The farmer’s tax attributes are the same as those for the Bankruptcy Exception and Insolvency Exception except that in adjusting the basis of the taxpayer’s property, only farm property is adjusted.

Exclusion 4—Qualified Real Property Business Indebtedness

Debt forgiven or cancelled is not taxed to the extent that it is Qualified Real Property Business Indebtedness. Qualified Real Property Business Indebtedness is (1) debt incurred or assumed to acquire, construct, or improve property in connection with real property used in a trade or business, (2) debt secured by the property acquired, and (3) debt to which you elect to apply this exclusion. It also includes debt incurred to refinance Qualified Real Property Business Indebtedness, up to the amount being refinanced. (Note: You elect to apply this exclusion by claiming it on a timely filed tax return—if you file late, you lose the exclusion.)

If the debt cancelled qualifies for the bankruptcy exclusion, that must be applied first. If the debt qualifies for the insolvency exclusion, that must be applied before the Qualified Real Property Business Exclusion.

The amount that can be excluded under the Qualified Real Property Business Exclusion is limited to the  excess of the outstanding principal of the Qualified Real property Business Debt (immediately before the cancellation) over the Fair Market Value of the business real property securing such debt (reduced by any other Qualified Real Estate Business Debt secured by the property, but not more than the adjusted bases of depreciable property held by the taxpayer immediately before the cancellation).

If you elect this exclusion, you must reduce the basis of your depreciable property (but not below zero) by the amount of cancelled Qualified Real Property Business Indebtedness. The basis reduction, like the other tax attribute adjustments, is made as of the first day of the tax year after the debt was cancelled.

Exclusion 5—Qualified Personal Residence Indebtedness

Cancelled Debt can be excluded from income if it is Qualified Personal Residence Indebtedness.

Monroe County, Michigan, reports that residential values in the County fell by 15% in 2009.

Qualified Personal Residence Indebtedness is debt incurred in acquiring, constructing, or substantially improving the taxpayer’s residence. Qualified Personal Residence Indebtedness also includes the refinancing of Qualified Personal Residence Indebtedness to the extent that the replacement debt does not exceed the amount of the debt replaced. The maximum that you may treat as Qualified Personal Residence Indebtedness is $1,000,000, on a single return, $2,000,000 on a joint return. Amounts in excess of this limit may be excludible under another exception.

The Exclusion for Cancellation of Qualified Personal Residence Indebtedness was added as a temporary measure effective January 1, 2007, and is scheduled to expire on December 31, 2012.

The only Tax Attribute that you need to reduce if you qualify for the Cancellation of Qualified Personal Residence Indebtedness Exception is the basis of the house itself.

Reporting Cancelled Debt

Cancelled Debt excluded from income is reported on Form 982. The Form requires the reporting of the type and amount of excluded debt cancellation, and the Type and amounts of Tax Attributes reduced.

Summary

There are several ways to avoid tax on the Cancellation of Debt. There are four Exclusions from the definition of Cancelled Debt: (1) Debt reductions as gifts, (2) Debt reductions of student loans under government or college programs, (3) Debt reduction for items that would be deductible if paid, and (4) Reduction in the contract balance by the Seller. In addition, there are five Exceptions to the rule that Cancelled Debt is taxable: (1) Bankruptcy (all types), (2) Insolvency (to the extent of insolvency), (3) Qualified Farm Indebtedness (Debt directly connected with farming), (4) Qualified Real property Business Indebtedness (real estate purchase or improvement), and (5) Qualified personal Residence Indebtedness (Purchase or improvement of the residence).

Each of the Exceptions requires the adjustment of Tax Attributes.

Resources:

Internal Revenue Code:

Section 108—Income from discharge of Indebtedness.

Section 1017—Discharge of Indebtedness.

Treasury Department Regulations:

1.108-4—Election to reduce basis of depreciable property under section 108(b)(5) of the Internal Revenue Code.

1.108-5—Time and manner of making the election under the Omnibus Budget Reconciliation Act of 1993.

1.108-6—Limitations on the exclusion of income from the discharge of qualified real property business indebtedness.

1.108-7—Reduction of attributes.

1017-1—Basis reductions following discharge of indebtedness.

Internal Revenue Service Publications:

4681—Cancelled Debts, Foreclosures, Repossessions and Abandonments (for Individuals)

Internal Revenue Service Forms:

Form 982—Reduction of Tax Attributes due to Discharge of Indebtedness.<–>

Conventional Individual Retirement Accounts have been with us since 1974. IRAs can be funded up to certain limits annually. The limits currently are $5,000 per year for people under age 50, and $6,000 per year for people over that age (up to the amount of the taxpayer’s earned income). If the taxpayer either doesn’t have another retirement plan, or his income is under certain limits, the contributions to the IRA can be deducted from taxable income. (The limits are $65,000 for a single person covered by a retirement plan, $109,000 for a married couple both covered by retirement plans, and $176,000 for married person whose spouse is covered by a retirement plan.) If the taxpayer is not eligible to make a deductible contribution, he may still make a non-deductible contribution—if he wants to keep track of the “basis” of the IRA on which tax has been paid for the rest of his life.

Roth IRAs have been around since 1997. Roth IRAs can be funded up to the same annual limits as conventional IRAs. Roth IRA contributions are not deductible from income, but qualifying withdrawals from Roth IRAs are totally tax free.

Taxpayers have been allowed to “convert” conventional IRAs into Roth IRAs since Roths have existed, by paying income tax on the amount converted. For many years only taxpayers with Adjusted Gross Income of less than $100,000 (excluding the conversion) were allowed to convert their IRAs into Roths.

Beginning in 2010 there is no longer an income limit on converting a conventional IRA (or some other defined contribution retirement accounts) into a Roth IRA. Many more people will qualify, and many will find it advantageous.

The reasons to convert to a Roth IRA are:

1. Convert to avoid future tax rate increases.
2. Convert to use your tax-sheltering attributes.
3. Convert to make your taxable savings tax-free.
4. Convert to maximize funds passed to your heirs.

1. CONVERT TO AVOID FUTURE TAX RATE INCREASES

Do you expect that tax rates will increase over the rest of your life? We seem to be asking government to do more and more for us, which eventually will increase our tax bills.

If you expect tax rates to go up, you can “lock in” present tax rates on your IRA by converting to a Roth. If you convert this year, you can pay this year’s rates. Future income on your retirement account, and future withdrawals are tax free.

Locking in the present tax rates may turn out to be a wise move if rates increase, even for people who plan to use their Roth IRA to fund their retirement. Roth distributions are not listed on your tax return, so disadvantages that are based on Adjusted Gross Income are reduced: less of your Social Security benefits are taxed, or less are taxed at the higher rates. Property tax credits to low income taxpayers  are increased. Reductions of itemized deductions or exemptions might be avoided. Alternative Minimum Tax rules might be avoided by having less  taxable income.

2. CONVERT TO USE YOUR TAX-SHELTERING ATTRIBUTES

Do you have tax attributes that make your tax rate this year exceptionally low? A Net Operating Loss or a Disaster Loss? Early retirement with little taxable income? Charitable contribution carryovers? Exceptionally large itemized deductions?

If you have any tax attributes that wipe out your income, consider taking advantage of them by filling the tax-free hole with otherwise taxable retirement funds. Be more aggressive, and withdraw enough to use the entire 10% and 15% tax brackets. It’s unlikely you will regret it. You may be able to make a series of withdrawals to convert your retirement into a Roth at little or no cost—and have the Roth advantages described below.

3. CONVERT TO MAKE YOUR TAXABLE SAVINGS TAX-FREE

Roth conversions work best when the tax on the conversion can be paid with funds that would otherwise produce taxable income. The funds are paid to IRS, and no longer produce taxable income. Your annual tax bill is reduced. Other taxes, costs, and lost deductions, such as the portion of Social Security subject to tax, or property tax relief based on having low Gross Income, will also be moved in your favor.

Equivalent funds within the Roth which would someday have been paid as taxes from a conventional IRA are growing TAX-FREE. That’s tax-free now, and tax-free in the future. Totally tax-free.

4. CONVERT TO MAXIMIZE FUNDS PASSED TO YOUR HEIRS

Retirement plans receive special tax treatment, including tax deduction on their creation, and tax-free growth, in order to provide funds for seniors to live on in retirement. To encourage the notion of providing funds for retirement the Tax Code provides that participants must take mandatory distributions after age 70-1/2. These Required Minimum Distributions create taxable income for the participant, and tax for the United States Treasury. Once the Required Minimum Distributions start, the participant is not allowed to make further contributions to the IRA. (Otherwise participants might simply trade dollars, taking their Required Minimum Distributions, but making an equivalent contribution to the IRA.) Required Distributions encourage the use of the funds during retirement, rather than using the retirement accounts as a vehicle to transfer wealth to the next generation.

Roth IRAs have no Required Minimum Distributions. Since the funds are not taxable on withdrawal, Congress did not provide for mandatory withdrawals during the participant’s life. Roth IRAs can be left entirely alone for the participant’s whole life, if he has other funds to live on. The original Roth, and all of its growth, can be used to pass wealth to the next generation.

Along with the right to maintain the Roth IRA without mandatory distributions, there is no age at which a person having earned income can no longer contribute to a Roth. People who continue to work after age 70-1/2 can continue to add to their Roths.

If you can avoid distributions from your retirement fund, you can continue its tax-free growth.

The people who inherit the Roth (that is, your heirs) are required to withdraw it over their life expectancies, but the period of tax-free growth can be substantial. What other property can you pass on to your heirs  where their income will be tax-free, part of it for the heir’s whole life expectancy.

FEATURES OF A ROTH IRA

Roth IRAs are designed to be created with after-tax money, and are totally tax-free. They can only be created by two methods: using the normal contribution rules for IRAs, or by converting a retirement account into a Roth IRA. Originally only IRAs could be converted into Roth IRAs. Under the current rules, other retirement accounts as well as IRAs can be converted into Roth IRAs upon paying the tax.

Annual contributions can be withdrawn from the Roth IRA at any time after their contribution tax free (after all, the contributions were made with after tax money). IRA conversions to Roths are also tax free, but are subject to an early withdrawal penalty if they are withdrawn within the first five years. After 5 years there is no early withdrawal penalty, and after five years an the participant’s age 59-1/2, all withdrawals are totally free of tax.

If you are the participant considering conversion to a Roth IRA, you are thinking of the advantages of many years ‘ of tax-free growth. But remember, this is YOUR money for all of your life, and if you need it, you can withdraw it.

When there was an income limit on Roth conversions, it was possible for people to convert their IRA into a Roth IRA, and later find that their Adjusted Gross Income was over $100,000, so the conversion was not allowed. To help these people out, the law provided for a “Recharacterization” of the withdrawal: If you wished, any time before your tax return was due, with extensions(that is, up until October 15 of the year following the year of conversion), you could “recharacterize” the Roth IRA as a traditional IRA, meaning that you had simply made a “rollover” of a conventional IRA, and you owed no tax.

With the new rules in 2010 there is no maximum Adjusted Gross Income limitation on the conversion, so there is no reason for allowing a “recharacterization”. Nevertheless, Congress left the provisions in the Code, so it is still available for use. Presumably people will find it useful if the value of their IRA decreases before the final day of making the “recharacteriaztion” election, converting the previous year’s conversions back into a conventional IRA (no tax due on that simple rollover), and converting the now less valuable IRA to a Roth the next year at a lower tax cost.

In fact, you might convert your conventional IRA into two or three Roth IRAs, each invested in different securities. When the final election day came (which could be over 21 months from the initial conversions) the accounts that lost money could be “recharacterized” back to conventional IRAs, for last year’s tax return, and converted again into a Roth in order to lower the tax cost of their conversion. The accounts that had increased in value would be left as completed conversions.

Conversion of retirement funds into Roth IRAs involves projecting likely results several years into the future. It must be done carefully, and should generally be done with professional help. This article is only meant to suggest some of the situations in which a conversion can be beneficial.

References:

Internal Revenue Code:

Section 408A Roth IRAs

Treasury Regulations:

Section 1.408A-0 Roth IRAs; table of contents

Section 1.408A-1 Roth IRAs in general

Section 408A-2 Establishing Roth IRAs

Section 408A-3 Contributions to Roth IRAs

Section 408A-4 Converting amounts to Roth IRAs

Section 1.408A-5 Recaracterized contributions

Section 1.408A-6 Distributions

Section 1.408A-7 Reporting

Section 1.408A-8 Definitions

Section 1.408A-9 Effective Date