SECTION VIII

§§ 108 and 1017: DISCHARGE OF INDEBTEDNESS

SUGGESTED ANALYSIS

1. Mr. Nice loaned Mr. Glad $10,000. Mr. Glad is not insolvent and
not bankrupt. Mr. Glad pays Mr. Nice $7,000 and tells him he's
not sure he'll be able to come up with the remaining $3,000
because he is recovering from a heart attack and has been
unable to work. Mr. Nice is interested in future business from Mr.
Glad and so decides not to force Glad to pay him. Nice tells Glad
that the $7,000 payment entirely settles the debt. Ignoring all
interest income or deduction issues, what are the tax
consequences to Mr. Glad?

Borrowing of money does not give rise to income. There is no accession to

wealth because the cash received is offset by the liability to repay. However,
if the debt is cancelled without the borrower having to repay it in full, the
borrower has an accession to wealth equal to the amount of the debt that no
longer needs to be repaid. The accession to wealth created by the
cancellation of indebtedness was first ruled to be income by the US Supreme
Court in the Kirby Lumber case in the materials and is now codified in
§ 61(a)(12).

Section 108 provides a number of exceptions to the income rule of

§ 61(a)(12). When the discharge occurs as part of a formal Federal
bankruptcy court proceeding, and the debt is cancelled by the court, it is
excluded from income. However, sometimes the cancellation is a private
affair, done directly between the debtor and creditor. In that situation, the
availability of an exclusion depends on a number of factors including, but not
limited to, the nature of the underlying transaction, the use to which the
borrowed funds were put, whether or not the debtor is solvent and the
nature of the assets the taxpayer owns.

There are a number of issues you must address in any discharge situation.
This first question is whether or not there has been a relief from debt or was
the debt, in fact, fully satisfied by the transfer of services or property in
addition to, or in lieu of, money? If it has been fully paid through cash,
property and/or services, or a combination thereof, there is no cancellation
of indebtedness. Note however, that when property or services are used to
pay off an obligation there will be tax consequences. The amount of debt
cancelled in exchange for services will give rise to services income. The
amount of debt cancelled in exchange for property will trigger a deemed sale
of the property. In essence, these will be taxed as barter transactions.

If the total value of cash, property and services transferred to the lender is
less than the full amount of the debt, then you will have cancellation of debt.
You then go to the second question of whether there is an exception to
§ 61(a)(12) somewhere else in the Code. The first place to look is § 102.
Was the cancellation of the debt a gift? If the cancellation qualifies as a gift,
then the income is excluded under § 102(a) and we never get to § 108. If it
is not a gift, then you must look to see if § 108 provides any assistance.

In this problem, Mr. Glad pays Mr. Nice $7,000 in full settlement of the
$10,000 debt. There has been a discharge of $3,000 of debt which will be
income under § 61(a)(12) unless an exception applies. Section 102 won't
work to exclude the income as a gift since the forgiveness is not coming
from detached generosity but from a hope of future business. Where the
discharge has business or economic motivations, it will not be a gift. Thus,
Glad will have $3,000 of discharge of indebtedness income unless an
exclusion under § 108 applies, and nothing does.

2. How would your answer to Problem 1 change if Mr. Nice had no

business connections with Glad but just felt sorry for Glad's
situation and so forgave the remaining debt?

Now § 102(a) might exclude the $3,000 of income as a gift. It depends on

an understanding of Nice’s intent.

3. How would your answer to Problem 1 change if Mr. Glad pays

Mr. Nice $7,000 in cash and, in addition, performs $3,000 worth
landscaping work for Mr. Nice?

We need to break this transaction down into its component parts. First, does
Glad have relief of indebtedness? The answer is NO! He owed Nice $10,000
and he paid him the full $10,000 when he gave him $7,000 in cash and
provided services worth $3,000. Glad has fully paid off the debt so there is
no cancellation of indebtedness income.

But we are not done. Mr. Glad has provided services in payment of the debt.
Whenever you have an exchange you have the potential for income. The tax
consequences will be that same as if Glad performed the services, billed Nice
$3,000 for the services, Nice paid him the $3,000, and then Glad turned
around and used the $3,000 to pay off the remaining part of his debt. Glad
has $3,000 of compensation income that he must recognize. Since the
income is not from cancellation of indebtedness, § 108 cannot apply to
exclude the income.
4. How would your answer to Problem 1 change if Mr. Glad pays
Mr. Nice $7,000 in cash and, in addition, gives Mr. Nice his
automobile which has a fair market value of $3,000 (and which
Mr. Glad originally purchased for $10,000)?

This calls for the same analysis as the prior problem. He owed Nice $10,000
and he paid him the full $10,000 when he gave him $7,000 in cash and a car
worth $3,000. Glad has fully paid off the debt so there is no cancellation of
indebtedness income. But Glad has “sold” his Volvo for $3,000 in the
exchange. This deemed sale may have tax consequences to Glad if Glad
uses the automobile in his business and has taken depreciation deductions.
If this car was just for the personal, nonbusiness use of Glad, the $7,000
loss is a nondeductible personal loss. § 165(c)

5. Joe sold Tom a computer that had been hand built by Joe. The
purchase price was $10,000. Tom paid Joe $6,000 cash and
signed a promissory note to pay Joe the remaining $4,000.
Thereafter, Tom complained that the computer was defective
and not worth $10,000. In order to resolve the dispute, and in
hopes of getting future business from Tom, Joe agreed to forgive
the $4,000 note. Tom's liabilities, including the note, total
$100,000. The fair market value of his assets is $110,000. What
are the tax consequences to Tom?

The first question is whether Tom has discharge of indebtedness income.

Clearly he does. He owed Joe $4,000 and the debt has been cancelled
without any payment by Tom. The § 61(a)(12) income cannot be excluded
as a gift since Joe doesn't have the requisite motivation for forgiving the
debt. The facts tell us that the cancellation was motivated by a business
dispute and the hopes of future business.

Now we must look at § 108 to see if there is an exception. Some of the

exceptions in § 108 first requires us to determine whether or not Tom is
insolvent. Insolvency is defined in § 108(d)(3) as the excess of liabilities
over the fair market value of assets, determined immediately prior to any
debt discharge. Here the facts tell us his assets are $110,000 and his
liabilities are only $100,000. He is solvent.

With a solvent taxpayer, there are three potential exclusions under § 108:
1) § 108(e)(2) – no discharge of indebtedness income if the payment of the
liability would have given rise to a deduction; 2) § 108(e)(5) – reduction of a
debt owed by a purchaser of property to the seller, which arose out of the
purchase transaction, treated as a reduction in purchase price rather than
income and 3) § 108(c) – Discharge of qualified real property business
indebtedness.

In this problem § 108(e)(5) provides us with the only possible exception.

Under § 108(e)(5), a reduction in the purchaser's debt to the seller of
property is excluded from income and treated as a purchase price reduction.
For the provision to apply, the debt must be between the buyer and seller of
property and must relate to the sale of the property. We meet these
requirements and Tom will exclude the $4,000 from income.

What are the consequences of § 108(e)(5) applying? We are told to treat it

as a “purchase price reduction.” But purchase price reduction is no where
defined. When Tom bought the computer, his basis in the computer was
$10,000 because he paid $10,000 - $6,000 cash and $4,000 debt. With the
debt being forgiven, it is treated as if the purchase price was originally only
$6,000. We find this rule in the Congressional Committee Report.

Further, a taxpayer using § 108(e)(5) must reduce the basis in the specific
property relating to the debt. S. Rep't No. 96-1035, 96th Cong., 2d Sess. 16
(1980) However, there are some issues here. There are no rules that tell you
what to do if the property was previously depreciated and there is not
enough basis left to reduce in the property or if Tom no longer owns the
computer at the time of the discharge. The likely answer is that any excess
depreciation must be recaptured as income. When a taxpayer takes a
deduction, and in a later tax year an event occurs that is fundamentally
inconsistent with the premises on which the deduction was based, the
deducted amount must be taken back into income. Hillsboro National Bank
v. Commissioner, 460 US 370 (1983). This is generally known as the “tax
benefit rule.”

6. Peter rents an office that he uses exclusively to conduct his

business. He owes the landlord $2,000 in back rent. The landlord
believes Peter is a good lessee and a potential business
generator. The landlord forgives the $2,000 unpaid rent. What
are the tax consequences to Peter?

Peter has a $2,000 debt discharged and will have income unless an
exception applies. The income cannot be excluded under § 102 since the
motivation for the cancellation was the hope of future business, not
detached generosity. Therefore, we must look to § 108.

Under §108(e)(2), discharge of indebtedness income is excluded if payment

of the indebtedness would have given rise to a deduction. The facts are
silent on whether or not Peter is solvent, but for § 108(e)(2) it doesn’t
matter. It applies whether or not the debtor is solvent.

The question is whether, had Peter paid the rent on his business office he
would have received a business rent expense deduction. The answer to this
question is “maybe” – it turns on Peter’s method of accounting. For the
payment to give rise to a deduction, Peter must be on the cash method. If
Peter was an accrual basis taxpayer, he would have already accrued and
deducted the rent and § 108(e)(2) would not apply. Thus, the § 108(e)(2)
exclusion generally applies where a trade account payable of a cash basis
taxpayer is forgiven.

What are the consequences of § 108(e)(2) applying? Peter has no income

from the cancellation of his obligation to pay rent and gets no business
expense deduction for the unpaid rent.

7. Sam borrowed $80,000 from Ted, his brother's business partner,

to purchase gardening equipment. Sam has run into some rough
times and offers to pay back only $50,000 of the loan. Ted does
not want to disrupt his already tenuous business relationship
with Sam's brother and therefore accepts the $50,000 as full
payment of the debt. Immediately before Sam paid the $50,000,
his balance sheet was as follows:

Assets Adjusted Basis Fair Market Value

Gardening equipment $10,000 $50,000

Other business assets $65,000 $75,000
Cash $75,000 $75,000

TOTALS $150,000 $200,000

Liabilities (including $250,000

the $80,000 debt)

Assuming Sam has no "tax attributes" other than his basis in the
assets shown on his balance sheet, what are the tax
consequences to Sam?

As always, the starting point is § 61(a)(12) which says Sam has $30,000 of
income (he settled $80,000 of debt for $50,000). Section 102 is not
applicable because the debt was forgiven for business concerns and not
detached generosity. We now look to see if any of the § 108 exclusions
apply.
The first question is whether Sam is solvent or insolvent. Section 108(d)(3)
defines insolvency as an excess of liabilities over the fair market value of
assets. Here his liabilities are $250,000 and the fair market value of his
assets is $200,000. Therefore, Sam is insolvent.

We now must look to the insolvency exceptions: 1) § 108(e)(2) – no income

to the extent payment would give rise to a deduction; and 2) § 108(a)(1)(B)
– discharge occurring when taxpayer is insolvent. Since the payment of the
principal of a loan never gives rise to a deduction, §108(e)(2) will not apply.
However, § 108(a)(1)(B) will exclude the full $30,000 of cancellation of
indebtedness income.

What are the consequences of the exclusion? Section 108(b)(1) requires that
when income is excluded under § 108(a)(1)(A) – (C), the taxpayer must
reduce his "tax attributes" by the amount excluded. Section 108(b)(2)
provides for attribute reduction ordering rules. Since the facts tell us that
Sam has no tax attributes other than basis in his assets, we wind up at §
108(b)(2)(E) which requires Sam to reduce his basis in his assets (§
108(b)(2)(E)(i)) according to the rules in § 1017 (§ 108(b)(2)(E)(ii)). (Note
that unlike Problem 7 where there was a reduction in the basis of
depreciable real property only, under § 108(b)(2)(E) we look to the basis of
all assets, regardless of whether they are real or personal, depreciable or
nondepreciable.)

We are sent of § 1017 which generally tells us the which assets should have
their basis reduced. However, § 1017(b)(2) is more important here. It
provides a limitation on the required basis reduction in situations where the
taxpayer is bankrupt or insolvent. The required basis reduction is limited to
the extent by which the basis of the taxpayer’s assets after the discharge
exceeds his liabilities after discharge. In other words, don’t reduce the basis
of the assets below the total amount of debt left.

Here the basis of Sam’s assets after discharge is $100,000 (It was $150,000
reduced by the $50,000 in cash used to partially pay off part of the debt).
His liabilities after discharge are $170,000 ($250,000 - $80,000). Since his
liabilities after the discharge are greater than the basis in assets after the
discharge, the maximum required basis reduction under § 1017(b)(2) is zero
and the “mandatory” basis reduction in § 108(b) does not have to be made
after all! This is one of the few situations where there can be an exclusion
under § 108 with no consequence to the taxpayer.

8. How would your answer to Problem 7 change if Sam also has a

net operating loss carryover from prior years of $30,000, with
and without all available elections?
The answer to this problem turns on whether Sam makes an election under
§ 108(b)(5).

No Election

Under the § 108(b)(2) attribute reduction rules, NOL is the first listed
attribute to go. His NOL would be reduced to zero and there would be no
reduction in the basis of his assets.

With Election

The § 108(b)(5) election allows the taxpayer to apply the attribute reduction
against the basis in depreciable property first, skipping over the higher
ordered attributes. Sam could elect to skip over his NOL and reduce the
basis in his depreciable assets instead.

The election under § 108(b)(5) can only be made to the extent Sam has
basis in depreciable property. (Note that what we are looking for is not basis
in depreciable real property, or basis in all property, but only basis in
depreciable property, real or personal) § 108(b)(5)(B). That is because
under § 108(b)(5)(A) a basis reduction in depreciable property is required to
the extent that the § 108(b)(5) election is used to skip over higher listed
attributes. Since a basis reduction in depreciable assets is required, the
election is limited to the extent of the available basis in depreciable assets.

Can Sam make the election under § 108(b)(5) and then use § 1017(b)(2) to
eliminated Sam’s obligation to reduce basis (as was the case in Problem 9?
No! The flush language in § 1017(b)(2) says that its limitation on basis
reduction does not apply if the § 108(b)(5) election is made.

The maximum which Sam could elect depends on how much of the basis he
has in his depreciable property, which we are not told.

Note also that the election is not all or nothing. Section 108(b)(5)(A) says
that the election may be made with respect to “any portion” of the required
tax attribute reduction. Sam will either have to reduce the NOL by $30,000,
the basis of his depreciable assets by $30,000 (assuming he has $30,000 of
basis in depreciable assets) or some combination of the two adding up to
$30,000.

9. How would your answer to Problem 7 change if immediately

before Sam paid the $50,000 his balance sheet was as follows?
Assets Adjusted Basis Fair Market Value

Gardening equipment $40,000 $50,000

Other business $115,000 $115,000
assets $75,000 $75,000
Cash
$230,000 $240,000
TOTALS

Liabilities (including $250,000

the $80,000 debt)

Sam still has $30,000 of § 61(a)(12) income, Under these facts Sam
insolvent – the fair market value of assets of $240,000 is less than the debt
of $250,000. On its face, § 108(a)(1)(B) will provide an exemption.
However, § 108(a)(3) provides a limitation on the amount of income which
can be excluded under the insolvency exception. The amount excluded under
§ 108(a)(1)(B) cannot exceed the amount by which the taxpayer is
insolvent.

Sam is insolvent by only $10,000 ($240,000 assets - 250,000 liabilities).

Therefore, he can exclude only $10,000 of income § 108(a)(1)(B) and the
remaining $20,000 is taxable under § 61(a)(12).

The excluded $10,000 must be run through § 108(b)(2) attribute reduction

ordering rules. Since Sam has no tax attributes other than property, we are
back to § 108(b)(2)(E) basis reduction in property which again puts us into
§ 1017. We must therefore test to see whether the limitation on the
mandatory basis reduction provided by § 1017(b)(2) applies.

After the transaction, the basis Sam has in his assets is $180,000 ($230,000
- 50,000 cash pay down of loan) and his liabilities are $170,000 ($250,000 -
80,000). Therefore, under the § 1017(b)(2) the most we have to reduce
basis is $10,000, which would bring the basis of the asset down to the level
of the debt. Since we only have an adjustment of $10,000 to make, we must
make it all.

It should be noted that once we exclude $10,000 of debt relief Sam is now
solvent! (His assets are $240,000 and his liabilities are $240,000). We can
now look to see whether any of the solvency exceptions apply to exclude the
remaining $20,000 of cancelled debt. Since the payment of the debt would
not give rise to a deduction and the debt was unrelated to the purchase of
property or business real property, unfortunately there are no grounds to
exclude the remaining $20,000.