2020 goal: Exclude debt discharge income

In good times, tax advisers spend a lot of time thinking about how to report gains as tax-favored net capital gains.

This allows the taxpayer to pay a lower tax rate than would apply if the gains were “ordinary” income.

In other times, advisers instead work to avoid income when a taxpayer has debt forgiven or reduced in amount as the result of a troubled debt workout. So we have a largely recession-proof profession.

Well, 2020 falls into the “other” times category.

Expect debt failures. In the category of “adding insult to injury” the tax law says you have income if you borrow money and don’t pay it back. This is specifically enumerated as an item of gross income by the tax law.

The logic behind this tax result was first spelled out by the Supreme Court in a 1931 decision Kirby Lumber Co. The court explained that if borrowed money is not repaid, the borrower has experienced a “freeing of assets” that adds to wealth.

Assume that you have $1 million of assets (I said assume) and $300,000 of debt. You have a net worth of $700,000. Of your $1 million, $700,000 is yours and, in a sense, $300,000 must be earmarked to repay the creditor.

Now assume the creditor says “don’t repay me.” The full $1 million is now yours! You have freed up $300,000 of assets that otherwise would have been used to repay the creditor.

IRS says, “Good for you!” And says Tiny Tim, who became an IRS tax auditor, “God bless us everyone! You have some extra money and can share some of it with us.”

The Supreme Court first found the share-thewealth approach fair, and Congress later changed the law itself to explicitly say this.

But, wait, you say, this is not what you mean when you refer to 2020, is it? No, it is not. The law also has many exceptions to this general rule of income from discharge. The easiest to understand says no income if you are insolvent.

Let’s say that your assets fall to $100,000 in my above example with $300,000 of debt. You are now insolvent (debts exceed asset value) by $200,000. So if the loan is forgiven, you only free up assets if that forgiveness exceeds $200,000. The law then says the first $200,000 of forgiveness is not income.

Other exceptions exist also, but require the use of definitions rather than the computations used to measure insolvency.

A discharge in a Title 11 bankruptcy case can be excluded.

A discharge of qualified farm debt can be excluded as can a discharge of qualified real property debt. Both of these are defined in very specific ways.

A discharge of qualified principal residence debt can also be excluded through the end of 2020. This provision always gets extended, expires and gets extended again. If 2020 continues the way it started I expect this one to be extended beyond 2020.

Some debt is called “non-recourse” because the lender’s rights are limited to taking the property that secures that debt. The lender cannot come after the borrower for other assets he or she may own.

Non-recourse debt cannot create income from a discharge of that debt, because the borrower was never personally liable. When a borrower returns the collateral to cancel the debt, the tax law treats this exchange like a sale.

If the amount of the nonrecourse debt exceeds the basis of the property that secures that debt, a gain from sale is realized. This gain cannot be excluded from one of the exceptions noted above. The gain from a deemed sale when non-recourse debt is satisfied may be capital gain if the security is a capital asset. In contrast, discharge of debt income, if not excluded, is always ordinary income.

For tax advisers, 2019 was a year to try to classify ordinary gains as capital.

For 2020 it’s looking like a year of trying to exclude debt discharge income.

And the seasons they go round and round, the painted ponies go up and down … and we go round and round and round in the circle game. As Yogi Berra ... said, “It’s déjà vu all over again.”