Section 108 codifies and limits court-developed rules that govern the discharge of indebtedness of debtors who are in bankruptcy or insolvent. Section 108 also provides rules governing discharge of indebtedness of a (1) taxpayer’s qualified farm indebtedness (§ 108(a)(1)(C)), (2) a non-subchapter C taxpayer’s qualified real property business indebtedness (§ 108(a)(1)(D)), and (3) a taxpayer’s qualified principal residence indebtedness discharged before January 1, 2014 (§ 108(a)(1)(D)).
- ”Qualified farm indebtedness” is debt (but not purchase money debt) that a taxpayer incurred “in connection with” taxpayer’s operation of a farming trade or business, § 108(g)(1). The lender – and so the party discharging the debt – must be a government agency or an unrelated person engaged in the business of lending, § 108(g)(1)(B) (referencing § 49(a)(1)(D)(iv)). After making adjustments to tax attributes under the insolvency provisions of § 108, § 108(g)(3)(D), a solvent taxpayer may exclude debt that the lender discharges up to the sum of taxpayer’s adjusted tax attributes plus the aggregate adjusted bases of trade or business property or property held for the production of income. §§ 108(g)(3)(A), 108(g)(3)(C). Taxpayer then reduces tax attributes as per § 108(b) and § 108(g)(3)(B). Section 1017(b)(4) governs the bases reduction(s). The “qualified farm indebtedness” rules give solvent farmers many of the benefits that § 108 gives to insolvent debtors.
- ”Qualified real property business indebtedness” is debt (other than “qualified farm indebtedness”) that taxpayer incurs or assumes “in connection with” real property that secures the debt that taxpayer uses in a trade or business. § 108(c)(3)(A). The amount discharged reduces the bases of taxpayer’s “depreciable real property” to the extent that the loan principal immediately before the discharge exceeds the fmv of such property (less the principal amount of any other loans that the same property secures). § 108(c)(2)(A). Section 1017(b)(3)(F) governs the bases reduction(s). The amount of such basis reduction(s) cannot in the aggregate exceed the adjusted bases of all of taxpayer’s depreciable real property determined after reduction of tax attributes because of insolvency or bankruptcy or for reduction of qualified farm indebtedness. § 108(c)(2)(B). This provision should reduce the incentive of a taxpayer to walk away from encumbered property that is (or was) “under water,” despite the fact that a lender has been willing to discharge some of the debt.
- ”Qualified principal residence indebtedness” is up to $2M of debt that taxpayer incurred to acquire, construct, or substantially improve taxpayer’s principal residence, which secures the loan. § 108(h)(2), § 108(h)(5). The amount discharged reduces taxpayer’s basis in the home, but not below $0. § 108(h)(1). Congress enacted § 108(a)(1)(E) in response to the financial crisis and to encourage homeowners not to default on their home mortgages when they are “under water.” Notice that unlike the case of “qualified real property business indebtedness,” the amount of permissible basis reduction is the taxpayer’s basis in the home, not the amount by which taxpayer’s basis exceeds the property’s fmv. This provision will not apply to discharges of “qualified principal residence indebtedness” that occur before January 1, 2014.
- Another measure that Congress adopted in response to the financial crisis is § 108(i). During the ongoing financial crisis, corporations may engage in Kirby Lumber-type transactions, i.e., they may purchase their own debt for less than the amount that they borrowed. Corporations and other taxpayers engaged in a trade or business may restructure their debts by acquiring them for cash, for another (modified) debt instrument, or for an equity interest. A business with serious cash flow problems – which gave rise to the restructuring in the first place – may not be in a position to pay income tax on resulting doi income because doi income is not income that a taxpayer realizes in cash. Section 108(i) permits taxpayers with doi income resulting from the reacquisition of debt during 2009 and 2010 to defer recognition until 2014 and then to recognize a ratable portion of that debt over a five-year period. § 108(a)(1).