Excluded Debt Forgiveness Bites Back Earlier than Expected

Excluded Debt Forgiveness Bites Back Earlier than Expected

Photo Source: TaxRebate.org.uk

Now that the tax extension deadline is behind us, we can focus on sharpening the saw, figuratively speaking. It’s not often that basis issues are a part of an IRS controversy. So when a case comes out that addresses basis issues specifically, it’s worth noting. And in this case, we also get a lesson in Qualified Real Property Business Indebtedness (QRPBI).

Tax Court Decision – Hussey v. Commissioner

The Tax Court announced its decision in Hussey v. Commissioner in June 2021. Mr. Hussey acquired 27 real estate properties during 2009 and took on $1.7 million in debt secured by them. That year was not a time of easy profits in the real estate industry, and Mr. Hussey ended up selling 16 properties in 2012, of which 15 were sold at losses. His bank didn’t fare too well in the transaction, as it sent Mr. Hussey 15 Forms 1099-C, Cancellation of Debt, for 2012 to document the discharge of $754,054.

For 2012 Mr. Hussey used the same tax preparer as in prior years. This accountant prepared a Form 1040, U.S. Individual Income Tax Return, with a Form 4797, Sales of Business Property, that reported gains on the properties of about $84,000.

Perhaps Mr. Hussey wasn’t too happy with this result. His financial advisor questioned it and referred him to a CPA working for a large firm, who referred him to a tax attorney. The tax attorney prepared an amended 2012 return that reported a loss on the sale of the properties exceeding $613,000.

Because Mr. Hussey had wisely elected to treat the debt as QRPBI using Form 982 filed with his return, he didn’t have to add any cancellation of debt income (CODI). IRC §108(a)(1)(E) provides for that, and the IRS didn’t raise this issue. The IRS and Mr. Hussey disagreed about when Mr. Hussey should reduce the tax attributes of the property he sold.

Reducing Tax Attributes After Debt Forgiveness

The general rule is taxpayers should reduce tax attributes in the year following the discharge of indebtedness. Because Mr. Hussey sold the properties in 2012, he should have reduced the basis in the property on January 1, 2013, following the general rule in IRC §1017(a). However, the IRS contended at trial that it didn’t apply, and it pointed to a different part of the same section, IRC §1017(b)(3)(F), as evidence.

This subsection provides a special rule for QRPBI overriding the general rule. In limited cases, the reduction in tax attributes takes place immediately before the disposition of the properties. The cases are limited to situations in which the cancellation of debt income excluded from income is less than the aggregate adjusted bases of the depreciable real property. IRC §108(c)(2)(B) provides this qualification for the special rule to be in effect, so the Tax Court applied it.

After examining the legislative history, the Tax Court agreed with the IRS. Mr. Hussey did not have to include the cancellation of debt income on the properties. But he did have to reduce the tax attributes to reflect the lower basis in the year of the sale, 2012. The court decision does not indicate if this is the result reported in the originally filed 2012 tax return.

Final Decision by the Tax Court

Mr. Hussey won on another point, however. The Tax Court decided that Mr. Hussey had reasonably relied on his attorney’s advice, so he was not subject to the substantial understatement penalty for his 2013 and 2014 tax returns. The IRS had suggested that Mr. Hussey had been “shopping” for a more favorable tax result, so it believed he was not relying on his attorney’s advice in good faith. The Tax Court disagreed and struck down the substantial understatement penalties.

Here’s the moral of the story. A tax practitioner should be careful with basis issues for real estate sold in the same year that a lender cancels debt secured by it.

By John W. Richmann, EA