Guest Post: William Tubb

Operation Occupy Rupe's Blog

I've known the esteemed Mr. Tubb for years on-line. Many of you will know him better as bronsont. He's the best of eggs.

On most Fridays you can hear him calling out his beloved lobster bisque for lunch, causing all within earshot jealousy we're not with him during this particular repast. We all drool a bit, grumble a lot and then go about our business ... albeit a bit sadder.

Regarding a bio, Mr. Tubb declined, instead stating only this about his post below: "Just tell 'em it was a dare & they should learn from this to never make a dare."

Ladies and Gentlemen?

May I present Mr. William Tubb ...

.......................... Ruprecht ( STOP )

Last week, by happenstance, I was made aware of Operation #OccupyRupe’sBlog. Naturally I immediately began making as many snarky comments as possible to our good buddy Rupe, offering my assistance, but in areas he could not possibly accept. Well we all know Rupe isn’t one to be trifled with, and he immediately called my bluff challenging me to present my offering or zip it!

I proposed a posting on the Bonus Depreciation available to taxpayers in tax year 2011. Now I ask you, who in their right mind would allow such to be included in their pride and joy of a Blog? The answer to that is simple … Rupe!

Being a hillbilly of the first order, fresh from the foothills of the Smokeys of Tennessee, and having consumed copious quantities of both Rolling Rock and moonshine, although seldom in the same glass at the same time, I am a very perceptive fellow. I felt the average reader of Rupe’s fine publication would give something less that rapt attention to a dissertation of Bonus Depreciation. What to do? What to do? What to do?

After several days studiously pondering the question, and several sessions of Rolling Rock/Moonshine consumption & fortification the answer came to me. The handling of Cancellation of Debt Income on the Federal Form 1040!

In today’s hard economic times, and in today’s horrendous housing market, I see several clients each year showing up at my desk with those pesky 1099-A and 1099-C documents in hand with the question, “Are these

things important?” The simple answer is, Hell Yes! The forms 1099-A and 1099-C notify the IRS that you, the taxpayer, had something happen in your life which, absent an explanation from you, the IRS assumes was a taxable event.

These events can be triggered by several things. You have all seen television commercials with the spokesperson offering to help you beat the terrible credit card company to their knees and get you relief from both the usurous interest charged and the principal debt on your credit cards. When the bank or credit card issuer agrees to forgive all or a portion of the debt you owe, BAM taxable event. You all know someone who is short selling or has lost their real estate to foreclosure, BAM taxable event. In essence what has happened is the lending institution paid you money, allowing you to pay off your debt, and that good friends is income.

Also ANYTIME that you have a foreclosure or repossession TWO separate and distinct things happen:

a. you may or may not have taxable cancellation of debt income
b. you ALWAYS ALWAYS ALWAYS have a “deemed sale” of the property involved and need to account for it being sold on the tax return. Either by schedule D or form 4797 whatever is appropriate for the type of property. Remember the term “deemed sale” as it is important.

Let us consider several situations:

1. Taxpayer gets a 1099-C only for something not involving repossession or foreclosure:

Assuming this is a non-business bad debt it must generally be included as income on line 21 (Other Income) of the taxpayers tax return unless you can exclude it using the insolvency option.

A. Go over your financial status if it appears you are insolvent; fill out an “insolvency worksheet”. You need accurate numbers NOT estimates and that includes any sums you have in retirement plans. (see the page about insolvency worksheets for more detail)

B. After completing the insolvency worksheet you now need to review it to ensure it is complete. You then need to fill in the “Statement of Income from Discharge of Debt” (this statement is included in my software

package, but I can’t honestly say if it is in popular individual packages like Turbo Tax or Tax Cut. I would suggest seeing a professional if you find yourself in this situation, the cost of doing it wrong could be much higher than the cost of a tax professional, but if you feel comfortable with the concept, see the page about that statement for more details)

C. Once you have it, you need use that data to fill in the form 982

D. You now also need to complete a “Federal Statement” that details what you did and what attributes were reduced and by how much

E. Any amounts not excluded must then be included in income on line #21 Other Income and added to your total income.

2. Taxpayer gets a 1099-C or combination of 1099-A and 1099-C for their personal residence.

This scenario assumes that ALL of the debt owed on this home was “qualified mortgage debt”. If not the issue is more complicated. If so this is the easiest of all scenarios to do a return for because it falls under the provisions of the “2007 Mortgage Debt Forgiveness Act”.

I. If the home was not repossessed but the bank simply reduced the amount that the taxpayer owed to them to get the payments down.

A. Fill in form 982 line 10b with the amount of debt forgiven. The only attribute that needs to be reduced is the basis of the home (line 10b)

B. You now also need to complete a “Federal Statement” that details what you did and that the basis of the principal residence was reduced from X to Y. It would also be used to explain any combo of 1099-A and 1099-C if that occurred.

II. If the home was repossessed:

A. There are no attributes to be reduced since the taxpayer no longer owns the home as of the beginning of the next tax year

B. You need to account for either a 1099A or a 1099 C to show the sale. Usually this is done on a schedule D if there is a profit then you can add a line showing a section 121 exclusion (assuming they qualify). The section 121 exclusion is the $250,000 if single, or $500,000 if married filing jointly of profit on the sale of a primary residence which is tax free if the house has been owned by the taxpayer and used as a primary residence for at least 2 years of the 5 years before the sale. If you have a loss on the sale, it is a non-deductible personal loss. You cannot assume the IRS knows this is a personal home that is not taxable you must account for the sale somewhere on the return.

C. You will also need to complete a “Federal Statement” detailing what you did. It would also be used to explain any combo of the 1099-A and 1099-C if that occurred.

NOTE: Remember Qualified Mortgage Debt (QMD) is ONLY that debt that is incurred to Buy, Build or improve the home. For example;

a. Someone buys a home for 200,000 and has a 150,000 mortgage on it. That is all QMD.
b. When their Mortgage balance is down to 125,000 they refinance and now have a mortgage of 195,000 because they used the extra money for trips or whatever. Only 125,000 of that 195,000 is qualified mortgage debt,
c. When their Mortgage balance is 125,000 they hit the lottery and pay off the mortgage. Several years later their finances have eroded and they need cash so they refinance the home for 200,000. NONE of this amount is QMD.
d. When their mortgage balance is 125,000 they refinance the home for 200,000 to put an addition on. The addition cost 55,000. Their QMD is 180,000 other 20,000 of debt is not QMD.

3. Special case - Taxpayer gets a 1099-C or combination of 1099-A and 1099-C for their personal residence BUT they have non QMD debt that was forgiven.

The important thing to realize here is that any NON QMD amount is always taxed first. Any remaining amount can be disposed of using the “2007 Mortgage Debt Forgiveness Act”. For example:

a. A taxpayer had a 300,000 mortgage on a home that was foreclosed on. The FMV of the home foreclosed on was given as 170,000. Of the 300,000 mortgage debt only 160,000 was QMD. This means the taxpayer has 130,000 of COD income. Because the non-QMD portion of their mortgage was 140,000 that means NONE of the COD income is excludable under the “2007 Mortgage Debt Forgiveness Act”. You need to use insolvency to get them out of any COD income taxation.

b. Same case but the QMD portion was 220,000 and the non QMD 80,000. They still have 130,000 of COD income but in this case you can exclude 50,000 using “2007 Mortgage Debt Forgiveness Act” and the

remainder using insolvency using two for 982’s –OR- you can elect to use insolvency only for the entire amount if that works out the same or better for the client

You would complete the return using the methods already outlined in #2 and/or #4.

4. Any other property that was foreclosed on or repossessed including rental real estate:

A. Go over your financial status if it appears you are insolvent, then fill in the “insolvency worksheet”. You need accurate numbers NOT estimates and that includes any sums you have in retirement plans. (see page on insolvency worksheets for more detail)

B. When you complete the insolvency worksheet you now need to review it to ensure it is complete. You then need to fill in the “Statement of Income from Discharge of Debt” (see page on that statement for more details)

C. Once you have that, you need to use that data to fill in the form 982

D. You also need to account for the “deemed” sale of the property on a schedule D or form 4797 whatever is appropriate.

E. You now also need to complete a “Federal Statement” that details what you did and what attributes were reduced and by how much. I would also mention how the “deemed sale” was accounted for on this statement.

5. Special Case – Foreclosure and COD income based on a rental property

You do not always have to try to exclude COD income. If a taxpayer has a rental property foreclosed on and he has lost a lot of money on it, it might be simpler to enter the COD income as rental income (and not even

try to get the taxable income exclusion) then sell the property as you would normally using the form 4797. The end result is often the same with less hassle and less cost. You can try it both ways there is often little or

no difference in the end result. And…yes you would need a “Federal Statement” to explain the 1099C disposition and tell how you entered it as income on the Sch E.

Insolvency Worksheet

The IRS allows taxpayers to exclude from income any amount of cancellation of debt income(COD) that exceeds their net worth just before the COD occurred.

Assuming that you are in this situation, you need an idea of just how much tax might be due. I will usually do the easy part of the return first saving this till last. I then enter the COD on line 21 or Sch C or Sch E

wherever it might properly go. This shows what will be owed IF you do not try to minimize this income.

To determine insolvency you need to fill out the insolvency worksheet that lists ALL of your assets and liabilities immediately before the date of the cancellation. You cannot do this quickly. You will need to do your homework and enter the data in an orderly manner and fill out the other forms when you have time. It is my experience that there are always questions and modifications to the original data. If the COD is a joint amount you do it for the couple, if it is for an individual you ONLY fill it out for that person . If an individual COD then any joint assets/liabilities are counted 100% for that person.

You will also need to know in most cases the adjusted basis of the assets:

- immediately after the insolvency AND
- at the beginning of the next tax year.

This data will be needed to calculate something called “the basis limitation” on the “Statement of income from discharge of debt” which is discussed in the next section.

Once completed and you have added up all of the numbers you will know whether or not you are insolvent. If so continue with the process.

Note: Just because you are insolvent does NOT mean that ALL of the cancellation of debt is forgiven as taxable income.

For example: If all of your assets total 105,000 and your liabilities total 200,000. Then you are insolvent by 95,000. If you had 150,000 of debt cancelled then only 95,000 of that would be excluded and they would have

(150,000-95,000) 55,000 of taxable cancellation of debt income.

Statement of Income from the Discharge of Debt

This is the important form that generates the information that feeds on to the form 982. If your software does not have this statement, again you should see a professional, but you could visit one and ask for a copy of a blank form for your personal use.

Part IV. Is the most difficult part. The IRS gives and the IRS takes away. The rules may allow you to cancel debt BUT they also require the taxpayer to surrender other potentially useful tax deductions or credits (they call them tax attributes) in return, up to the amount of the amount of debt cancelled.

Part IV is where you calculate these amounts. There is what is called an “ordering rule” that requires you to reduce them in a specific order. The order is as listed on that worksheet.

Assuming that you still have things to reduce by the time you get to line 18c. You will need to do additional calculations. MOST time you do need to do these calculations. The reason is that the IRS does limit the amount of property basis that needs to be reduced and these calculations determine that limitation. To properly complete this part you will need to calculate it using the following data:

Line 18a The ADJUSTED basis of assets other than money at the beginning of the year following the year of discharge.

Line 18b is calculated by taking the adjusted basis of all assets including money immediately after the debt was cancelled and subtracting the amount of debt remaining

Line 18c is the lower of line 18a or 18b assuming you were insolvent.

That is the amount that you will have to use to reduce the value of any of the remaining assets. BUT you are not done yet. There is ANOTHER “ordering rule” that specifies the order in which the value of those remaining assets are to be reduced. It is in pub 4681. If you have more than one item in a category that needs to have its basis reduced you need to reduce them pro-rata.

For example if you get to that point and have two rental properties remaining with and adjusted basis of 200,000 for property A and 150,000 for property B. Assuming that there was 100,000 worth of cancelled debt that remained to have attributes reduced on, you would do the following calculation:

Property A’s basis would be reduced by (200,000/350,000) X 100,000=57,140
Property B’s basis would be reduced by (150,000/350,000) X 100,000=42,860

I hope you have enjoyed this little epistle, and more I hope you realize if you or a friend happens to be in this situation you need professional assistance.

Now Rupe bet me that I could not better his post of 11/21/11. Please be so kind as to back track, read that fine work (please access this link), and let us know which one made your head hurt and eyes cross the most.