Taxpayers who did not establish insolvency must recognize COD income

Taxpayers who settled a credit card debt for $4,412 less than they owed in 2008 had to include that amount in income because they did not prove they were insolvent under Sec. 108(a)(1)(B) at the time of the debt discharge (Shepherd, T.C. Memo. 2012-212).

Sec. 108(a)(1)(B) excludes cancellation of debt (COD) income from gross income if the debt discharge occurs while the taxpayer is insolvent. The taxpayers, Bernard and Desiree Shepherd, claimed to be insolvent in 2008 when the credit card company cancelled their debt. At issue in the case was the fair market value (FMV) at the time of the debt discharge of two pieces of real estate the Shepherds owned: their principal residence and their vacation home. In addition, the parties disagreed whether the value of Bernard Shepherd’s state pension should be included in the taxpayers’ assets when calculating the insolvency.

The valuation of these assets would determine whether the value of taxpayers’ liabilities exceeded the total value of their assets, and therefore whether they were insolvent. If the Tax Court accepted the taxpayers’ valuation of their houses and excluded the pension loan from their liabilities (and the corresponding amount of the balance in the pension from their assets), petitioners would be approximately $32,000 insolvent and therefore would not be required to include the COD income in their income for 2008.

The Tax Court found the evidence the taxpayers provided for the FMV of the two residences did not meet the required burden of proof. Sec. 108(d)(3) requires the FMV of the taxpayer’s assets to be determined “immediately before discharge.” The taxpayers provided a stipulated settlement of the value of the vacation home for local real estate tax purposes of $380,000 for 2010, two years after the discharge. Besides not being a value contemporaneous with the discharge, the Tax Court noted that values for real estate tax purposes are not persuasive without other evidence corroborating them.

As for the principal residence, the taxpayers offered two documents to prove its claimed $380,000 FMV. One valuation was from a home loan modification program in 2011, three years after the discharge. The bank called this an “exterior broker price/opinion appraisal” but did not otherwise describe the property or the method of valuation. The other document was a tax bill from 2008–09, which also did not describe the property or how it was valued. The Tax Court held that neither document provided convincing evidence of the property’s FMV immediately before the debt was discharged. The Tax Court again noted that values for real estate tax purposes are not persuasive without other corroborating evidence. It further pointed out that New Jersey law specifically contemplates that the assessed value of real estate is not equivalent to its FMV.

The Tax Court also found that the taxpayers had failed to prove the FMV of the portion of Mr. Shepherd’s pension that was required to be included as an asset in calculating insolvency. 

Because the taxpayers failed to meet their burden of proving that the properties were worth the amount they claimed, the Tax Court held that they failed to establish that they were insolvent at the time of the debt discharge and therefore were not entitled to exclude the COD income from their gross income.

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.