Discharge “Discharge of Indebtedness” Taxes
I live in ground zero of the real estate crisis: Arizona. We’ve seen prices drop to pre-bubble prices, and it looks like they are going to drop some more.
Not only are the investors hit with the actual losses on their real estate investments, but also a large number of them are going to be hit with large tax bills in the years to come due to something called the Discharge of Indebtedness.
Discharge of indebtedness (DOI) is a fancy way for saying that the IRS believes that if you are relieved of an obligation to pay debt, your net worth has increased; and the IRS wants to be able to tax that increase in net worth. While there are some neat loopholes available, they are mainly for DOI on a personal residence, or if you are a real estate, “professional”. (If you have a full time job other than real estate, you probably aren’t a real estate professional.)
One simple way to avoid the DOI taxes is simply to go bankrupt. Under the tax code it specifically says that if the DOI is incurred after a bankruptcy is filed no DOI taxes apply. Keep in mind that you need to go bankrupt before the foreclosure or short sale. If you wait to go B.K. until after the short sale or foreclosure, chances are the tax debt is going to survive bankruptcy, which is going to be a massive hindrance to your ability to get back on with your life. I can’t tell you the number of people I’ve met who think that going B.K. is going to relieve them of this burden. It’s a real heartbreaker to tell people they filed B.K. for nothing, and the $200K tax bill is going to haunt them for years to come.
A couple of recent court cases highlighted some other interesting ways to manage the DOI tax liability. In the first case, the court took pains to highlight that the amount of the debt must be “definite and liquidated”. In this case, a taxpayer was disputing the amount of debt they had with Citifinancial and Chase. Evidently Citifinancial got tired of arguing about it and just issued the taxpayer with a 1099-C. The IRS received the 1099-C and was nice enough to assess taxes on the taxpayer for the relieved debt; pretty much standard stuff.
However, the taxpayer was not standard material. To their credit (sorry, couldn’t resist) they kept on fighting. In Tax Court they argued the 1099-Cs issued were incorrect. The court pointed out that the tax code provides that, “In any court proceeding if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return, and has fully cooperated, the Commissioner shall have the burden of producing reasonable and probative information concerning the deficiency in addition to the information return.”
In short, the burden of proof was on the IRS to prove the 1099s were correct. Apparently the IRS didn’t provide any information other than the 1099s, and so the court reduced the amount of DOI to the amount the taxpayers agreed was valid debt.
Moral to the story? If you are facing a large tax bill for DOI on a foreclosure or short sale, dispute the hell out of the debt: Argue fraud, truth in lending violations, RESPA violations, argue the world just isn’t fair, but argue and dispute the hell out of the debt before the short sale or foreclosure. This way you might have a chance when it comes tax time to show the debt was not bona fide or “definite and liquidated”.
The other DOI case was all about timing. In 2000 the taxpayer went through foreclosure with the bank getting $35K less on the foreclosure sale than the balance on the loan. Time dragged on, and it wasn’t until 2007 that the bank issued the taxpayer a 2006 1099-C for the $35K. The taxpayer ignored the 1099-C and didn’t report the $35K as income on their 2006 return. Thus the Tax Court case.
The taxpayer took the position that the debt was really discharged in an earlier year, not 2006. Once again the court determined the 1099-C wasn’t dispositive of the issue, rather, the burden of proof was upon the IRS to say otherwise. As the court so eloquently put it, the IRS, “did not present one scintilla of other evidence . . .”
Bang! The gavel came down on the side of the taxpayer saying the DOI was not income for 2006.
Moral of this story? If the creditor waits a couple of years to hit you with the 1099-C, you probably have a good defense.
Overall moral of this article? Kinda the same thing I wrote about last year. Do not accept. There are tools available to you if you are willing to fight.
Yeah, the above are long shots and may not work for everyone, but if you don’t try them, what are your results going to be? Then, if by some miracle they do work for you, how much money could you save? How much emotional trauma? Asset protection is not taking one simple step to achieve planning nirvana; instead it is a process to identify and fully utilize all the tools available to you.
Asset Protection World is ready to discuss your options for your Asset Protection Planning. Call us for a FREE consultation.
