Avoiding Discharge of Indebtedness Income
Suppose you have negotiated settlements of your credit card debts. Or maybe you have executed a short sale of your house. You are concerned about tax on discharge of indebtedness income. The creditor may report the discharge of indebtedness income to the IRS on a Form 1099-C, with a copy to you. It is always possible that the IRS may raise the issue of discharge of indebtedness income on audit.
Indeed Internal Revenue Code (“IRC") § 61(a)(12) does include in gross income subject to income tax “[i]ncome from discharge of indebtedness." IRC § 108 posits several exceptions to discharge of indebtedness income. One exception is IRC § 108(a)(1)(B), which excludes discharged debt from gross income to the extent the debtor-taxpayer was insolvent immediately before the discharge of indebtedness. A taxpayer is “insolvent" for this purpose to the extent the amount of his debts exceeds the fair market value of his assets. 
Discharge of indebtedness income excluded from gross income by virtue of IRC § 108(a)(1)(B) applies to reduce the taxpayer’s tax attributes in the order specified by IRC § 108(b)(2). Tax attributes include capital loss carryovers, basis of property, passive activity loss and credit carryovers, and foreign tax credit carryovers.
Another exception to recognition of discharge of indebtedness income is IRC § 108(a)(1)(E), which excludes from discharge of indebtedness income qualified principal residence indebtedness discharged before January 1, 2013. “Qualified personal residence indebtedness" is indebtedness up to $2,000,000 which was used to acquire, construct, or substantially improve the taxpayer’s principal residence, or to refinance such debt, and is secured by the taxpayer’s principal residence.  Discharged personal residence indebtedness excluded from gross income by virtue of IRC § 108(h)(2) applies to reduce the taxpayer’s adjusted basis in his personal residence. 
Where the qualified personal residence exception does not apply, the insolvency exception of IRC 108(a)(1)(B) may well be available. Except in the case of cash, cash equivalents, and listed securities, the fair market value of property is subjective. If the taxpayer’s property is appraised at the low end of the fair market value range, the taxpayer may indeed be insolvent.
If a forgiveness of indebtedness is truly gratuitous, the debtor can argue that the discharge is not income but a gift. 
The debtor can argue that the transaction was not a discharge of indebtedness, but a compromise of a disputed and doubtful debt. For example, the discharged debt may be a promissory note for which the debtor received no consideration or consideration that failed. Or the creditor may have induced the debtor to enter into the transaction by means of misrepresentations. If the debtor has such defenses, he should notify the creditor of them in writing, to make a record for compromising or avoiding the debt without realizing discharge of indebtedness income.
An advantage of the gift or compromise arguments is that they do not require reduction of the debtor’s tax attributes.
Issuance of a Form 1099 by the creditor is not determinative of realization of gross income by the debtor.  It a taxpayer asserts a reasonable dispute as to income reported with respect to the taxpayer on a Form 1099, the burden of proving that the taxpayer realized the income is upon the IRS.  If a taxpayer disputes income reported to the IRS as to him on a Form 1099, he should exclude the income from his income tax return, and attach to the return a statement explaining why he believes he did not realize the alleged income.
This article originally appeared on my blog--http:// blogs.forbes.com/stephendunn/--in September, 2010.
 IRC § 108(d)(3).
 IRC §§ 108(h)(2), 163(h)(3)(B).
 IRC § 108(h)(2).
 Helvering v. American Dental Co., 318 U.S. 322, 87 L. Ed. 785, 63 S. Ct. 577 (1943).
 Portillo v. Comm’r, 932 F.2d 1128 (5th Cir. 1991); Estate of Everett Gryder, T.C. Memo 1993-141, 65 T.C.M. 2298.
 IRC § 6201(d); Steed, Martin A., T.C. Summ. Op. 2009-121.