Two exceptions to the general provision of IRC § 61(a)(12) recognizing income from the discharge of indebtedness were tested recently in separate cases, but the taxpayers were not successful in either.
Argued before the U.S. Bankruptcy Court for the Eastern District of Tennessee, Higgins v. Commissioner involved discharge of indebtedness income following foreclosure on real property in Georgia. Matthew Higgins and his wife, Mary Ann, borrowed approximately $100,000 from New Century Mortgage Corp. to purchase the property, and when they stopped making payments a few years later, the lender foreclosed. A foreclosure can result in income to the mortgagor if at the time of foreclosure the fair market value of the encumbered property is less than the outstanding debt. Accordingly, when New Century later sold the property for $93,739 less than the Higginses’ debt prior to foreclosure, it reported income to them in that amount. On that basis, the IRS calculated a tax deficiency of $61,715 for 2005, for which it filed a claim in the couple’s bankruptcy proceeding. The Higginses were unable to present credible evidence to dispute the amount of income. However, they argued that an exception under section 108(a)(1)(B), for insolvency of a taxpayer, applied to them. Although the court was certain that the Higginses were insolvent at the time of foreclosure, they presented no evidence to show the extent of their insolvency. Since the court could not determine the amount, if any, of the income that should be excluded, the exception was held to be inapplicable.
In the other case, Payne v. Commissioner, the taxpayers’ income arose from credit card debt. Ancil Payne owed $21,270 on a card issued by MBNA America Bank. MBNA agreed to accept $4,592 in full settlement of his account, discharging $16,678. Payne and his wife, Mary, argued they did not have to include the latter amount on their joint return because of section 108(e)(5), which excludes purchase price reductions. They contended that a retroactive reduction in the interest rate by MBNA constituted an adjustment to the “purchase price” of the amounts loaned. But besides misapplying the provision, the taxpayers provided no evidence of any agreement by MBNA to adjust the interest rate, the court said.
The cases illustrate how the discharge-of-indebtedness income exclusion of section 108 must be closely construed and amounts documented. Taxpayers whose debt was discharged on or after Jan. 1, 2007, for a qualified principal residence may be able to take advantage of section 108(a)(1)(E), added by the Mortgage Cancellation Relief Act of 2007.
In Re Higgins, 101 AFTR2d 2008-910
Payne v. Commissioner, TC Memo 2008-66
Prepared by Laura Lee Mannino, CPA, LL.M., assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.