Author: Leon Clinton

Sometimes debts can pile up beyond a borrower’s ability to repay, especially if we are heading into a recession.

But lenders are sometimes willing to cancel (forgive) debts that are owed by financially challenged borrowers.

While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event.

General Rule: COD Income Is Taxable

When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs.

Fortunately, there are a number of exceptions to the general rule that COD income is taxable. You can find the exceptions in Section 108 of our beloved Internal Revenue Code, and they are generally mandatory rather than elective. The two common exceptions are:

• Bankruptcy
• Insolvency

The cost of being allowed to exclude COD income from taxation under the bankruptcy or insolvency exception is a reduction of the borrower’s so-called tax attributes.

You generally reduce these tax attributes (future tax benefits) by one dollar for each dollar of excluded COD income. But you reduce tax credits by one dollar for each three dollars of excluded COD income. You reduce these attributes only after calculating your taxable income for the year the debt cancellation occurs, and you reduce them in the following order:

1. Net operating losses
2. General business credits
3. Minimum tax credits
4. Capital loss carryovers
5. Tax basis of property
6. Passive activity losses and credits
7. Foreign tax credits

As mentioned above, any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.

This taxpayer-friendly rule allows the borrower to take full advantage of any tax attributes available for the year of the debt cancellation before those attributes are reduced.

Principal Residence Mortgage Debt Exception

A temporary exception created years ago and then repeatedly extended by Congress applies to COD income from qualifying cancellations of home mortgage debts that occur through 2025.

Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income—or $375,000 if the borrower uses married-filing-separately status—from the cancellation of qualified principal residence indebtedness. That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.

If you would like to discuss COD income, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• January 14, 2023

As you likely remember, the Section 1031 exchange allows you to sell a piece of appreciated real estate and defer all the taxes as long as you invest the entire proceeds in like-kind property.

And then consider this: a cost segregation study allows you to separate qualifying real estate into components with shorter depreciable lives that speed up deductions and, in many cases, create immediate write-offs.

Can you (a) defer a large gain via Section 1031 and (b) immediately create a large write-off on the new asset with a cost segregation study?

You can.

But if you will use cost segregation on the newly acquired Section 1031 asset, you may want to make the IRS Reg. Section 1.168(i)-6(c)(5)(iv) election because that applies cost segregation to the entire basis.

If you are thinking of combining the Section 1031 exchange with a cost segregation study and would like my input, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• January 9, 2023

You may have noticed that the IRS is in a bad way.

It has a backlog of millions of unprocessed paper tax returns, and taxpayers can’t get through to the agency on the phone. Congress noticed and took action by passing a massive funding of the IRS in the recently enacted Inflation Reduction Act.

The IRS will get an additional $80 billion over the next decade. This includes $35 billion for taxpayer services, operations support, and business systems. Among other things, the IRS plans to use these funds to update its antiquated IT systems (some of which date back to the 1960s), improve phone service, and speed up the processing of paper tax returns.

Despite what you may have heard in the media, the IRS will not expand by 87,000 new employees. It will still be smaller than it was 30 years ago. It may grow by 20,000 to 30,000 workers over the next decade, and the number of revenue agents could increase to 17,000 by 2031—over twice as many as today.

The IRS will have an additional $45 billion to spend on enforcement. Treasury Secretary Janet Yellen has promised that IRS audit rates will remain at “historical levels” for taxpayers earning less than $400,000 annually.

Audit rates will rise for taxpayers earning $400,000 per year. If you’re in this group, it’s wise to plan ahead to avoid trouble with a beefed-up IRS.

You should keep complete and accurate records and file a timely tax return. Of course, this is something you should be doing anyway.

Here are a few special areas of concern:

• Cryptocurrency. You can expect increased IRS audits dealing with cryptocurrency transactions. If you’re one of the millions of Americans who engage in such transactions, make sure you keep good records and report any income you earn.

• S Corporations. If you’re an S corporation shareholder-employee, you should have your S corporation pay you an arguably reasonable salary and benefits, and document how you arrived at the amount.

• Syndicated Conservation Easements. Be aware that the IRS is auditing all of these deals, and its scrutiny of them will likely grow.

• Offshore Accounts. You’re supposed to report these to the U.S. Treasury. Failure to do so subjects you to substantial penalties. In recent years, the IRS has gone after banks and bank account holders who hide assets in offshore accounts. In future years, we can expect the IRS to place even greater emphasis on identifying and tracking such offshore assets.

• Partnerships. Partnerships and multi-member LLCs taxed as partnerships (this describes most of them) are already the subject of the Large Partnership Compliance program, which uses data analytics to select large partnership returns for audit. The IRS will likely devote more resources to this program in the future.

If you have any questions about this infusion of money into the IRS, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• January 3, 2023