In general, when a taxpayer is relieved of a debt he owes, he recognizes income under Section 61. This income – often referred to as “cancellation of debt” income, or COD, can be excluded in certain situations by bankrupt or insolvent taxpayers. There are also a host of other exclusions provided for under Section 108 that may reduce or eliminate a taxpayer’s COD income given the right circumstances.
In 2009, Congress had the foresight to recognize that COD income was going to become a frequent occurrence under the current economic landscape, and sought to offer some relief to those taxpayers who recognize COD income but can not avail themselves of the Section 108 exclusions.
Thus was born section 108(i), which provides that a taxpayer may elect to defer COD income with respect to the “reacquisition” of an “applicable debt instrument” during 2009 and 2010 and include it ratably in income over a five year period beginning:
(1) For a reacquisition occurring in 2009, with the fifth tax year following the tax year in which the reacquisition occurs.
(2) For a reacquisition occurring in 2010, with the fourth tax year following the tax year in which the reacquisition occurs.
An “applicable debt instrument” is essentially any debt issued by a C corporation or by any other person in connection with the conduct of a trade or business. There is limited guidance as to the meaning of a “trade or business,” but many practitioners believe that this would include debt issued in connection with the acquisition of depreciable rental real estate.
The types of debt forgiveness that expressly qualify for the deferral option include:
(1) An acquisition of the debt instrument for cash.
(2) The exchange of the debt instrument for another debt instrument
(3) The issuance of corporate stock or a partnership interest in exchange for the debt instrument.
(4) The contribution of a debt instrument to capital.
(5) The complete forgiveness of a debt instrument by a holder of such instrument.
(6) The partial forgiveness of a debt instrument
What is noticeably absent, however, from this list is COD created when a taxpayer has property used in a trade or business foreclosed upon. When a taxpayer transfers property secured by recourse debt (i.e., the lender can not only seize the property to settle the debt, but can also pursue the borrower personally) in satisfaction of the debt, the taxpayer recognizes COD to the extent the forgiven debt exceeds the FMV of the property. This has become an increasingly common reality for many taxpayers who find themselves unable to make mortgage payments on rental real estate property during the economic downturn.
Since there is no “reacquisition” of debt as defined above, it would appear the deferral under Section 108(i) does not apply to the very situation where it is likely needed most, when property is given to a lender through a foreclosure or deed in lieu of foreclosure in settlement of a recourse debt.