To File or Not To File: How the Timing of the Bankruptcy Can Impact the Exclusion of Cancellation of Indebtedness Income

Mark Ericsson

In this era when homes are often worth less than the loans they secure and of dropping or nonexistent incomes, more and more people are forced to consider walking away from their homes.   In a foreclosure or short sale, the banks holding the note and deed of trust will receive less than full value for their note.  This gives rise to cancellation of indebtedness income. It has long been tax policy that when a debtor is released from a debt, that person has become wealthier and therefore realizes ordinary income to the extent of that increase of wealth.  One of the driving forces in filing for bankruptcy is protection against taxes arising from cancellation of indebtedness income.

Since the concept of cancellation of indebtedness income is rooted in the theory that an increase in wealth results in income, taxpayers can exclude cancellation of indebtedness income to the extent the taxpayer is insolvent.  This is because the taxpayer’s creditors could have taken all the taxpayer’s assets both before and after the cancellation of debt and there is no change in position.  Since the taxpayer must prove insolvency, there is a degree of uncertainty in claiming the exclusion.

Bankruptcy provides a fresh start and in line with this philosophy, the cancellation of indebtedness income is automatically excluded.  However, in both the insolvency and bankruptcy settings, there is a price to pay.  Where the taxpayer emerges from bankruptcy with assets, the taxpayer must choose one of two ways to reduce the basis in those assets.  In better days, the taxpayer was likely to emerge from bankruptcy with no assets and was thus unaffected by this rule.  However, today, the taxpayer often emerges with property or tax attributes.

First, a taxpayer may elect to reduce the basis of his depreciable property by the amount of excludable income.  For example, if the debtor owns a home that is worth $500,000 encumbered by a $500,000 mortgage and has credit card debt of $100,000, he or she may be allowed to keep the home.  If the debtor purchased the home for $250,000, the basis will be decreased by the $100,000 in cancellation of debt income from the discharge of the credit card debt and the exclusion of the income.  Upon sale, the $100,000 in reduced basis will be taxed at capital gains rates.  The basis in bankruptcy estate assets is reduced first with any residual reduction applied against assets of the debtor.

If no election to decrease the basis of depreciable property is made, the taxpayer’s attributes are decreased in the order set forth in the code.  Net operating losses are first reduced by the amount of income that is excluded, followed by carryovers of business tax credits, carryovers of minimum tax credits, net capital loss carryovers, taxpayer’s basis in property (which has its own ordering rule), passive loss carryovers and foreign tax credit carryovers.  The credits are reduced one-third for each dollar of income.  The attributes are determined at the date of the filing of the petition.

Under either regime, the decrease in basis occurs on the first day of the year following the exclusion.  In the example above, if the taxpayer wants to sell the home, he has until the end of the year to sell the property to avoid the extra $100,000 in capital gain resulting from the reduction of basis.

The timing of the bankruptcy is important.  If the home is lost to foreclosure before the bankruptcy, the taxable event has occurred and the taxpayer reports the cancellation of indebtedness income.  If the tax was incurred within three years of the bankruptcy filing, the tax is non-dischargeable.  The tax liability becomes a debt of the bankruptcy estate and if there are sufficient estate assets, may be satisfied by the estate.

A note and deed of trust has two elements.  The note is a personal liability and that personal liability is discharged in bankruptcy.  The deed of trust is a security interest and if not stripped may survive the bankruptcy.  Therefore, if the short sale or foreclosure occurs during or after the bankruptcy, there will be no discharge of indebtedness income because the recourse debt has been discharged.

A reduction in basis generally converts today’s cancellation of indebtedness ordinary income into tomorrow’s capital gain.  In weighing a discharge in bankruptcy against incurring cancellation of indebtedness income, the advantage today of capital gain over ordinary income is huge.  However, this advantage will significantly diminish January 1 of next year if there is no intervening legislation.  With the debate over the Buffet rule, there is discussion as to why capital gains should get a break at all.  With so many variables, deciding whether to file a bankruptcy is not an easy equation.

Mark Ericsson practices taxation, business and estate planning law as a partner in the Walnut Creek firm Youngman & Ericsson, LLP, was the 2006 Contra Costa Bar Association president, and can be found at www.youngman.com.