Tax deferral available for business debt cancellation

There is good news and not so good news in preliminary guidance issued by the IRS in Revenue Procedure 2009-37 about business cancellation of debt.

The scope of debt cancellation eligible for tax deferral is much broader than I originally thought. The title of Internal Revenue Code Section 108(i), adopted on February 17, 2009 as part of the American Recovery and Reinvestment Act of 2009, is "Deferral and ratable inclusion of income arising from business indebtedness discharged by the reacquisition of a debt instrument." It turns out NO REACQUISITION IS REQUIRED. Deferral is available for any cancellation of business indebtedness.

Is debt cancellation for investment real estate held by an individual or a partnership (or LLC) eligible? According to Internal Revenue Code Section 108(i)(3), an "applicable debt instrument" means any debt instrument which was issued by (i) a C (regular) Corporation, or (ii) any other person in connection with the conduct of a trade or business by such person.

I asked IRS representative Craig Wojay, author of the Revenue Procedure, whether investment real estate would qualify as a "trade or business." Bear in mind that his response is not authoritative, but indicates the position of the IRS National Office. According to Mr. Wojay, debt to acquire investment real estate probably does not qualify, because it is not a "trade or business." Expenses for investment real estate are deducted under Internal Revenue Code Section 212; expenses for a trade or business are deductible under Section 162.

A trade or business requires more service involvement than an investment activity. An example of real estate used in a trade or business is a hotel or motel that provides lodging to transients (short-term tenants). On an individual income tax return, these activities would usually be reported on Schedule C (trade or business income) instead of Schedule E, Part I (rental real estate).

Since this legislation was enacted as a broad-based relief measure, some taxpayers may choose to challenge the IRS’s position.

Mr. Wojay told me he is receiving a lot of telephone questions about this issue and said the IRS should be issuing more guidance about it in the near future.

Why would you want to make the election to defer income from business debt cancellation?

When you make the election, income from cancellation of indebtedness after December 31, 2008 and before January 1, 2011 is reported over a five-year period. If the cancellation occurs in 2009, the five-year period begins with the fifth taxable year following the year of cancellation. If the cancellation occurs in 2010, the five-year period begins with the fourth taxable year following the year of cancellation.

Spreading the income over a five-year period not only postpones the potential tax but could make it easier to offset any other operating losses against the income. If the cancellation is eligible for exclusion because of insolvency or otherwise available under IRC Section 108(c) for business real estate, the accounting for deferral may be easier than for an exclusion because no reduction of basis is required for a deferral, but basis adjustments are required for an exclusion.

For example, if a taxpayer had a debt cancellation of $100,000 for a motel with a tax basis of $1,000,000 and chose to exclude the income under IRC Section 108(c), the tax basis of the motel would be reduced to $900,000. If the taxpayer chose deferral instead, there would be no basis adjustment and no change to the depreciation schedule for the property.

A taxpayer can choose to defer all or a part of the debt cancellation income. For the part for which deferral isn’t elected, the taxpayer can choose exclusion (if qualified) or to report currently as taxable income.

Revenue Procedure 2009-37 explains how to make the election and reporting requirements. The reporting requirements include annual disclosure of the balance of the untaxed deferred income. Partnerships and S corporations will be required to report the information each year on the owners’ Schedules K-1 until all of the income is reported.

The decision to defer or exclude cancellation of debt income shouldn’t be made lightly, but should be made under the guidance of a good tax advisor.

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