Some income not useable in bankruptcy

Situation:

The client is a resident of Kentucky for tax year 2008. Prior to moving to that state, she owned a personnel residence in Indiana. Due to certain circumstances, she filed for bankruptcy. The bankruptcy included consumer debt as well as the foreclosure on her principal residence.

The client asked her adviser whether the cancellation of debt has to be included in her gross income.

Solution:

Generally, under Internal Revenue Code Section 61(a)(12), income from discharge of debt is includible in gross income. This requirement affects taxpayers who lose their homes to foreclosures, default on consumer loans (e.g., automobile loans) or credit card debt.

However, under IRC Section 108, certain exceptions allow a taxpayer to exclude COD income from gross income. One of these exceptions occurs if the discharge happened when the taxpayer was insolvent.

In addition, Congress and President Bush passed the Mortgage Forgiveness Debt Relief Act of 2007, which provides that if the amount of debt forgiven is under $2 million on a principal residence, the taxpayer does not need to include the forgiveness in their income.

This exclusion applies to discharges made after 2006 and before 2010. The basis of the principal residence must be reduced by the amount excluded from gross income.

The client from Kentucky will receive relief from COD income because at the time she filed for bankruptcy, her liabilities exceeded her assets. The forgiveness of debt is due to the mortgage on her principal residence, which will be excluded as a result of the provisions under the Mortgage Forgiveness Debt Relief Act.

To receive the relief from COD income, the client must file Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness — and Section 1082 — Basis Adjustment) with her Form 1040, U.S. Individual Income Tax Return, on or before April 15. However, if she files an extension, she will have until Oct. 15 to file her return.

The client would indicate her insolvency by checking Box 1b and/or Box 1e for qualified-principal-residence indebtedness. By meeting the exceptions to IRC section 108(a), she is able to exclude certain COD income from taxable income.

Tax INsight is prepared by experts who are active members of the American Institute of Certified Public Accountants. Tax INsight appears on the web and in IN Daily every Tuesday. Comments are welcome at IN_Editor@InvestmentNews.com.

IndyMac Plans Chapter 7 Filing

IndyMac files for bankruptcy

Former UBS banker to plead guilty