Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
A Field Guide to Cancellation of Debt Income
Martin J. McMahon, Jr. and Daniel L. Simmons*
The United States is awash in a sea of debt. In June 2009, there was more than $14 trillion of mortgage debt outstanding—approximately $11 trillion on one to four family residences, approximately $900 billion on multifamily residences, slightly more than $2.5 trillion on nonfarm nonresidential real estate, and $111 billion on farms. Over $2.5 trillion dollars of consumer debt was outstanding as of May of 2009. At the end of June of 2009, over $ 1.2 trillion of commercial paper was outstanding. At the end of the first quarter of 2009, over $11 trillion of nonfinancial business debt, approximately $7.2 trillion of which was owed by corporations, was outstanding.
Many individuals and businesses are drowning in that debt. In the midst of the most severe recession since the Great Depression, major corporations, such as the American icon General Motors, have been unable to pay their debts and have gone into bankruptcy. Millions of individuals and small businesses have defaulted on their debts. Loan delinquencies and charge-offs are at levels heretofore unknown in the modern financial era. According to the Federal Reserve Board, bank loan charge-off rates more than quadrupled from the first quarter of 2006 to the first quarter of 2009; the charge off rate in the first quarter of 2009 exceeded 2%. In that same period, loan delinquency rates more than tripled and stood at 5.6% in the first quarter of 2009. Almost 8% of residential real estate loans and 6.4% or commercial real estate loans were in default. In the spring of 2009, the Mortgage Bankers Association reported that the share of loans entering foreclosure rose to 1.37%, the highest on record going back to 1972. The number of bankruptcies filed in 2008 totaled 1,117,771, up from 850,912 bankruptcies filed in 2007.
Every loan charge-off and mortgage foreclosure has tax consequences. While the creditor most often claims a bad-debt deduction or business-related loss, the debtor generally must recognize gross income and pay income taxes on an amount roughly equal to the creditor’s loss, unless a special exception applies to exclude the debt relief from income.
Almost every form of gross income required to be included under section 61 entails the receipt of money, property, or services of value (or the accrual of the right to receive money, property, or services in the year of receipt). The requirement that a debtor pay taxes when a loan goes unpaid is one of only a few situations in which a tax obligation arises without the contemporaneous receipt of valuable consideration. That the debtor must pay taxes in the year in which it is determined that a loan will not be repaid follows from the proposition that a borrower is not required to include loan proceeds in gross income upon receipt and thus not required to pay taxes at that time.
This Article deals with the tax consequences to the debtor of the discharge of a debt for less than full payment. Part II explain the origins and rationale for the rule, now codified in section 61(a)(12), that requires the inclusion of “[i]ncome from discharge of indebtedness.” Part III examines the various events that trigger recognition of income under section 61(a)(12). Part IV deals with the manner in which the amount of income from discharge of indebtedness is computed. This part also discusses the tax consequences to a business entity that issues an equity interest to a creditor to satisfy a debt. Part V explores the myriad of statutory rules in section 108 that permit nonrecognition of income from discharge of indebtedness under particular circumstances, and the various ancillary consequences that follow from nonrecognition. Throughout, the Article will explore the relationship of income from discharge of indebtedness to realization of gain from the transfer of property to satisfy a debt by contrasting the tax consequences of transfers of property to discharge a debt with the consequences of discharge of a debt for less than full payment.
*Martin J McMahon, Jr. is the Stephen C. O’Connell Professor of Law, University of Florida Fredric G. Levin College of Law. Daniel L. Simmons is Professor of Law, University of California Davis School of Law, Vice-Chair, University of California Academic Senate.