Debt Help Delivered

Continued from “The Frustration of Bad Debt Part 1”

Cited: ABA Journal

Modification of Debt

By reducing the interest rate or extending the maturity date a creditor may agree to modify the terms of a loan or other debt.  If this is defined as “significant” under the Treasury regulation section 1.1001-3 will determine the tax consequences of such a modification.

Generally, a modification is significant under the regulation only if, based on all the facts and circumstances, the legal rights or obligations are altered in an economic manner and to a degree that changes the character of the debt in a major way.

A modification that changes the timing of payments, for instance, is significant if it results in the “material” deferral of scheduled payments. A deferral will be material if it extends a payment period more than five years or more than half of the original term of the loan, whichever is less. Other significant modifications in a debt may be indicated by changes in its yield to the creditor; the substitution of a new obligor replacing the original debtor on a recourse debt; a change in the collateral or guarantee on a nonrecourse debt; or changing the debt instrument from recourse to nonrecourse, or vice versa.

If the debt modification is not significant under the definition of the Treasury regulations, or if it was contemplated or provided for in the original debt instrument, then it generally has no tax effect.

If the modification is significant, however, the debt is deemed to be exchanged for new debt in a taxable exchange under IRC section 1001. In that case, the debtor will generally be treated as having satisfied the old debt with an amount of money equal to the issue price of the new debt.

Exclusions from COD Income

As discussed above, the general rule is that cancellation-of-debt income is treated for federal tax purposes as ordinary income to the debtor.

But COD income may be excluded if the debtor falls within certain exceptions enumerated in Internal Revenue Code section 108. (In the case of debtors that are partnerships, the exclusions are applied at the partner level; for S corporations, the exclusions are applied at the corporate level.)

The two most important exclusions are for bankruptcy and insolvency.

COD income is not recognized for tax purposes if the discharge of the debt occurs in a federal bankruptcy proceeding pursuant to a plan approved by the court—whether filed under chapters 7, 11 or 13. Under the bankruptcy exclusion, there is no limit on the amount of COD income that may be excluded.

The insolvency exclusion, however, applies only when, and to the extent, a debtor’s liabilities exceed the fair market value of assets determined immediately before the discharge, and income may only be excluded to the extent of the insolvency.

Assets exempt from the claims of creditors must be counted in determining whether the debtor qualifies for the insolvency exclusion. This could be a factor as to whether the debtor seeks to use the insolvency exclusion or, instead, restructure in a formal bankruptcy proceeding.

Contingent liability is another factor in the insolvency computation. In 1999, the 9th U.S. Circuit Court of Appeals based in San Francisco ruled in Merkel v. Commissioner that a contingent liability should be counted toward insolvency only if the debtor proves by a preponderance of the evidence that he or she will be called upon to pay that liability. This is an all-or-nothing test that makes it more difficult for debtors to establish that contingent liabilities should be taken into account to establish insolvency.

There are other exclusions from cancellation of debt income that may be available to debtors under IRC section 108:

• Qualified Farm Indebtedness.  A debtor may exclude COD income resulting from the cancellation of “qualified farm indebtedness,” which is debt incurred directly in connection with farming operations, if 50 percent or more of the debtor’s aggregate gross receipts for the three taxable years preceding the taxable year in which the discharge occurs is attributable to the trade or business of farming. The excluded amount may not exceed the sum of the adjusted tax attributes of the debtor and the aggregate adjusted bases of property held or used in a trade or business, or for production of income.
• Student Loans. This exclusion applies to certain student loans, but the discharge of the loan must be pursuant to a provision of the loan under which all or part of the indebtedness is discharged if the individual works for a certain period of time in certain professions for any of a broad class of employers.
• Qualified Real Property Business Indebtedness. This is debt incurred or assumed to acquire, construct or substantially improve real property used in trade or business, and that is secured by the property. But this exclusion, which is available only to noncorporate debtors, may not be used if the cancellation of debt occurs in the course of a bankruptcy proceeding or if the debtor is insolvent. The amount excluded generally may not exceed the amount by which the principal amount of the discharged debt exceeds the fair market value of the property securing the debt.
• Qualified Principal Residence Indebt­edness. Under the Mortgage Forgiveness Debt Relief Act of 2007, this exclusion applies only to the discharge of this kind of debt if it occurs on or after Jan. 1, 2006, and before Jan. 1, 2013. The indebtedness must be incurred to acquire, construct or substantially improve any qualified principal residence, and be secured by that property. The exclusion is limited to $2 million of COD income for a married couple filing jointly ($1 million for single filers and married persons filing separately), and it must be used to reduce the basis of the principal residence.

Those portions of the indebtedness can be considered to have been canceled first and therefore be treated as COD income if the indebtedness exceeds a certain monetary limit or a portion of it is used for a nonqualified purpose.

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My Take: Again, you need to be an accountant to understand this article.  When people think of bad debt they think of all the phone calls they are going to get from the company they own money to.  I think those companies actually use a call center to make those calls.  Of course, with all the bad debt that is going around right now, it does mean that somebody is getting the job, which is a good thing.

A contact center can provide customers a way to contact the business if they have a problem with a product or service.  But the bright spot is the employment, people getting a job because of somebody’s bad debt.  I just hope that the company utilizes good payroll services.  If they have good custom payroll program, they should not have any problems with employees not doing their job.

There is also a way to help your bad debt if you happen to have an old car sitting in your yard that does not work.  There are junk car removal services that will come and remove that old car from your yard for free when they purchase it.  There is a service that will buy junk cars online.  If it does not help with your debt, at least it’ll put groceries in the house.

Continued in “The Frustration of Bad DebtPart  3”

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