There are times in life when you may feel that you can’t get ahead. One step forward, two steps back–as they say.
Paying income tax on debt that you avoid is an example. You negotiate with the lender or creditor and they agree to settle the balance for less. One step forward.
Then a few years later, the IRS sends you a notice saying that you owe tax on the debt that was erased. The notices did not come for several years, so the notice factors in significant penalties and interest. Tax plus penalties and interest. Two steps back.
There are exceptions that can help avoid the two steps back. One of these exceptions applies when the debt consists of a loan on your primary residence.
The recent Weiderman v. Commissioner, T.C. Memo. 2020-109, case provides an opportunity to consider these rules. The taxpayer in Wiederman did not avoid the two steps back, but the case shows how others might be able to do so.
Facts & Procedural History
The taxpayers lived in Massachusetts. The wife was offered a job in California. To entice the taxpayer to take the job, the employer offered to loan the taxpayer $500,000 to purchase a home.
The wife took the job and purchased a $2 million dollar home in California. The taxpayers used part of the $500,000 loan to acquire the home. The loan was memorized in a promissory note, but the note was not filed in the county records. When their home in Massachusetts sold, they were able to pay down some of the other debt on the new California home.
About a year later, the wife’s employment was terminated. The employer demanded that she repay the $500,000 loan. Since the taxpayers could not pay the loan, the employer agreed to cancel $220,000 of the loan. The employer canceled the prior promissory note and had the taxpayers execute a new note for $280,000. The new note for $280,000 was recorded in the county records.
The employer ended up canceling $30,000 of the $280,000 loan the next year.
The IRS audited the taxpayers’ returns. It made several adjustments. The adjustments included an increase of taxable income for the cancellation of the $220K loan balance.
Litigation ensued in the U.S. Tax Court.
Cancellation of Debt Income
Generally, if a loan or debt is canceled or forgiven by the lender or creditor, the amount that is canceled or forgiven is considered income for the borrower or debtor.
Absent this type of rule, taxpayers could avoid the income tax by simply making loans to each other and then forgiving the loans.
When a loan or debt is canceled, the lender or creditor is supposed to file a Form 1099-C, Cancellation of Debt, with the IRS. The Form 1099-C alerts the IRS to the additional income. Many taxpayers receive these forms but then fail to report the canceled income on their tax returns. This falls into the category of problem tax returns. The IRS’s computer matching system typically catches this issue and the IRS’s computers mail the taxpayer a notice to increase their income.
Cancellation of debt can arise in a number of scenarios. For example, it often arises in civil litigation where one party compromises a debt.
While canceled debt is treated as taxable income, Congress has provided several exceptions. These exceptions allow taxpayers to avoid counting the canceled debt as income. These exceptions are why some taxpayers fail to report canceled debt.
The financial insolvency exclusion is the most common exception. But there are several other exceptions. They are set out in Section 108. As relevant here, Section 108 provides an exception for the discharge of acquisition indebtedness on a residence.
Cancellation of Debt on a Primary Residence
Section 108 says that gross income does not include debt discharged if the debt that is discharged is “qualified principal residence indebtedness” (and is discharged before January 1, 2021 or subject to an arrangement that is entered into and evidenced in writing before January 1, 2021).
The term “qualified principal residence indebtedness” incorporates the definition of “acquisition indebtedness.”
Acquisition indebtedness means any indebtedness which is (1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (2) is secured by such residence.
In the present case, the taxpayers argued that the $220,000 loan that was forgiven and then the $30,000 loan that was forgiven qualified for the exclusion for acquisition indebtedness.
The court did not agree. It noted that the first $500,000 loan was an unsecured loan. The promissory was not filed with the county clerk, which is required to secure the loan. This is also a requirement to be “acquisition indebtedness” for this exclusion.
The second $280,000 loan was secured, but, according to the court, this second loan was not acquisition indebtedness. The court noted that the debt was not used to acquire the residence. The debt was incurred to help sell the residence.
Hindsight is 20/20. There are several things the taxpayers could have done differently. For example, they could have filed the promissory note in the real estate records. They could have done this even though the employer, who was the lender in this case, did not do so itself.
For the second loan, they may have simply modified the original promissory note instead of executing a new promissory note. This might have allowed the $30,000 that was canceled to qualify for the acquisition indebtedness exception.
They may have also been able to argue that the second promissory note novated the first promissory note. Novation is a legal term whereby one contract is swapped for another contract. It is not clear if the court would allow novation to help bridge the two agreements, but, it would only matter if the original promissory note was secured. Since the original promissory note was not secured in this case, this argument would not help. But with hindsight and a little tax planning, this could have been an option if the employer/lender insisted on executing a new promissory note.