Can taxpayers avoid cancellation of debt income by structuring debt reductions as rebates or refunds? The court touched on this issue in French v. Commissioner, T.C. Summary Opinion 2018-36.
The Facts & Procedural History
The taxpayers borrowed money to purchase a home. When they failed to make their payments on the mortgage, the bank made contacted the taxpayers to collect the debt. The taxpayers entered into negotiations with the lender to restructure the debt. The final agreement resulted in the principal balance being reduced.
The IRS assessed cancellation of debt income (“CODI”) for the reduction in principal, which the taxpayers disputed. Litigation ensued.
Cancellation of Debt Income
Taxpayers do not pay tax on funds that are borrowed. The loan repayments are not deductible. But if the loan is settled for less than the amounted owned, the taxpayer will have CODI.
The CODI rules generally require a taxpayer to pay Federal income taxes on debts that are discharged.
The gist of this rule is that taxpayers are financially better off when debt is discharged, similar to other taxable events that trigger tax. The courts often refer to this as an “accession to wealth.”
There are a number of exceptions to CODI, which brings us to the the refund or rebate concept.
Refund or Rebate Concept
What if the taxpayer had made payments to the lender in the year of the CODI? Can some portion of the CODI be classified as refunds or rebates not subject to tax rather than CODI?
For example, if the taxpayer paid $10 to the lender during the year the lender discharged $100 of the taxpayer’s loan, can $90 be CODI and $10 be a nontaxable return of payments made? This was the argument in French. The taxpayers argued that a portion of the settlement agreement they made in the year of discharge was a return of mortgage payments they made that year.
The taxpayers cited CCA 200721017 in support for this position. CCA 200721017 addresses property taxes that were paid to the state and then refunded via a property tax rebate program. Generally, tax rebates are only included as income if they exceed the amount of taxes paid in.
The idea is that there is no CODI for refunds or rebates as there is no accession to wealth. Rather, the taxpayer is simply being put back in the position they were before the CODI.
Evidence of a Refund or Rebate
The court did not reject the theory, rather, it found that there was no evidence of a refund or rebate. The taxpayers did not include this language in the settlement agreement.
This leads to an question as to whether a taxpayer could include this type of language in a settlement agreement and thereby avoid CODI on what would otherwise be CODI? To continue the example, what if the full $100 was classified as a refund rather than CODI?
In addition to the benefit for the borrower, it should be noted that the lender might still be able to benefit from the refund or rebate. The lender may be able to restate their income or take a claim of right deduction or credit.