Chapter 8 9 and 11A

Question 1

Chapter 8
Discharge of Indebtedness

What is another name for Discharge of Indebtedness (DOI)?

Answer 1

a/k/a
Cancellation of Indebtedness Income (CODI)

a/k/a Cancellation of Indebtedness (COD)

Question 2

Chapter 8
Discharge of Indebtedness

What is the general rule of Discharge of Indebtedness?

Answer 2

General Rule - Inclusion: Section 61(a)(11) includes income from discharge of indebtedness in a debtor’s gross income.
Some DOI is Excluded: If the debtor is insolvent, in bankruptcy, or the debt is discharged in certain other transactions, Code section 108 may apply to exclude the DOI from gross income.

The Basic Transaction: The making of a loan is not taxable event for either the debtor or the creditor. But when the creditor forgives or discharges all or part of the loan, the debtor has income in the amount of the forgiveness or discharge.

To identify a potential discharge of debt situation, look for a creditor accepting (or being required to accept), in satisfaction of a debt, less than the creditor originally contracted to receive.

Question 3

Chapter 8
Discharge of Indebtedness

What is the loan creation?

Answer 3

Loan creation (non-event): For tax purposes (and for GAAP), the creation of debt is a non-event. No gain or loss is recognized by either the debtor or the creditor.

Although the debtor is enriched by the receipt of cash, she is correspondingly obligated by the creation of the debt.

Although the creditor obtains a receivable, the receipt is offset by the cash lent.

Example: Rita borrows $100,000 from Friendly Bank and uses it to purchase stock in Zoom Corp. She intends to hold the stock until the loan is due, then sell it, repay the loan, and keep the profit. Unfortunately, Zoom management ran the business into the ground. The company was liquidated and Rita received $10,000 in exchange for her stock. When the loan is due, Rita repays the bank in full, using $90,000 of her own savings. The tax consequences of the loan are independent of the transactions related to the stock. The loan and its repayment generate no tax consequences. With respect to the stock, Rita will report a $90,000 loss on liquidation (Code section 331).

Note:
A loan is defined as the “unconditional and legally enforceable obligation for therepayment of money.” Autenreith v. Commissioner, 115 F.2d 856 (3d Cir. 1940).

As a general rule, the loan is treated as an independent transaction from the debtor’s use of the loan proceeds. Each transaction generates its own tax consequences; the consequences of the use of proceeds do not affect the loan transaction. Vukosovich, Inc. v. Commissioner, 790 F.2d 1409 (9th Cir. 1986).

Question 4

Chapter 8
Discharge of Indebtedness

What is the loan repayment?

Answer 4

Loan repayment (non-event):  When a loan is satisfied at its contracted amount, this too is a non-event (for both Tax and GAAP).
Debtor:  Although relieved of an obligation, her assets have been correspondingly decreased (no net enrichment).

Creditor: Although cash is received, other assets (loans receivable) have been correspondingly decreased (no net enrichment).
Interest: A lender dealing at arms-length will require that interest be paid on the debt (i.e., the price for lending money). Interest is accounted for separately from the underlying debt.

Debtor: As the debtor pays interest, she may be able to claim a deduction for interest paid.
Creditor: As the creditor receives interest, it recognizes ordinary interest income.

Question 5

Chapter 8
Discharge of Indebtedness

What is the loan discharge?

Answer 5

Loan discharge (event): In a forgiveness or discharge situation, the creditor accepts, in satisfaction of all or part of the debt, something less than the creditor originally agreed to receive in payment of the debt.
Debtor:  The debtor realizes income in the difference between the amount of the debt owed and the amount of the debt paid (or to be paid if the debt is partially discharged).

Creditor: The creditor realizes a loss in the difference between the amount of the debt due and the amount of payment received (or to be received if the debt is partially discharged). This loss may or may not be deductible.

Example: Bank lent $50,000 to Kay. Kay lost her job and approached the bank with her reduced circumstances, offering to pay the $35,000 she received in severance in satisfaction of the debt. The bank agrees. Kay realizes $15,000 of DOI ($50,000 original debt less $35,000 amount paid). The bank realizes a loss in the same amount.

Question 6

Chapter 8
Discharge of Indebtedness

What is Realization Rationale?

Answer 6

“Freeing of assets” theory— United States v. Kirby Lumber Co., 284 U.S. 1 (1931): Kirby Lumber suggests that the discharge event made debtor assets available (that were previously offset by the debt) and, thus, gain was realized.

What if the debtor was bankrupt at the time of the discharge (i.e., its debt was in excess of the fair value of its available assets)? Were assets really freed up?

Economic benefit rationale: The more comprehensive explanation is that the debtor has income because discharge removes all or part of the offsetting obligation to repay, which prevented the debtor from having income at the creation of the loan. Thus the debtor has enjoyment of the loan proceeds (in whole or in part) without the offsetting obligation to repay, resulting in a net economic benefit to the debtor.

Note:
This economic benefit rationale is similar to the consistency rationale regarding the effect of nonrecourse debt on basis and amount realized in Tufts.

Question 7

Chapter 8
Discharge of Indebtedness

What is the definition of discharge?

Answer 7

Definition of discharge: Discharge is “forgiveness of, or release from, an obligation to repay.” United States v. Centennial Savings Bank FSB, 499 U.S. 573, 580 (1991). Discharge occurs when the taxpayer is relieved of a liability through the creditor (voluntarily or not) canceling or forgiving the obligation to repay, thus taking less than the creditor originally bargained for in satisfaction of the debt.

Examples of discharge:
When the creditor perceives that the debtor is unlikely to pay the full amount, the creditor may opt to take what it can get rather than waiting (perhaps in competition with other creditors) for the full amount. The difference between the face amount and the amount paid is the discharge or forgiveness.

Question 8

Chapter 8
Discharge of Indebtedness

What are examples of discharge?

Answer 8

Other Examples of Discharge:
Retirement of bonds: When a corporation issues bonds at a stated interest rate, it may seek to retire those bonds when interest rates fall in order to save interest costs. If the creditors (bondholders) take less than the face amount of the bonds in repayment of the bonds, the corporation will have discharge of indebtedness income in the amount of the difference.

Debt discharge income may be recognized on a debt-for-debt exchange, and a substantial modification of a debt instrument is treated as an exchange. See Reg. section 1.1001-3 for substantial modification rules.
Debt discharge income is recognized when stock is issued in retirement of debt if the stock is worth less than the debt.

Note:
Basically, if you owe less at the end of the day than you did at the beginning of the day as a result of the exchange / restructuring, there will be DOI.

Examples of substantial modification: Change in interest rates, extension of time to pay. These are present value concerns.

Question 9

Chapter 8
Discharge of Indebtedness

What is Bifurcated Transactions – Recourse Debt?

Answer 9

Transfer of property: When property is transferred in payment of recourse debt, basically two transactions occur:
The transferor is treated as selling the property to the creditor for its fair value (gain or loss realized depending on the difference between basis and fair value), and
The debt is paid (See Treas. Reg. sections 1.1001-2(a)(1) and -2(a)(2); and 1.1001-2(c)(8).

Fair value equal to debt: Assume that Henry owes $10,000 to Charlie. Henry pays Charlie by transferring stock with basis of $6,000 and value of $10,000 to Charlie. Henry realizes gain in the amount of $4,000 - the difference between the value of the stock ($10,000) and his basis ($6,000). Because the fair value of the stock is equal to the debt, there is no DOI.

Fair value less than debt: Assume, instead, that the fair value of the stock is $8,000. Henry realizes gain in the amount of $2,000 (value of $8,000 less basis of $6,000). Henry also realizes DOI in the difference between the amount of debt cancelled ($10,000) and the fair value of the property transferred in satisfaction ($8,000).

Why is this important (recourse bifurcated / nonrecourse not bifurcated)? Character. DOI is ordinary income and is also subject to certain rules (i.e., Code section 108 exclusion). Sale gain may or may not be ordinary and is not subject to Code section 108.

Note:
You would use a similar analysis with services. That is, if Charlie agreed to cancel the debt in exchange for Henry’s providing services worth $10,000, there would be no DOI (there would be service income). Similarly, if Charlie canceled the debt in exchange for Henry’s providing services worth $8,000, Henry would have $8,000 of service income and $2,000 of DOI.

Question 10

Chapter 8
Discharge of Indebtedness

What is Nonrecourse Debt – Not Bifurcated?

Answer 10

Code section 7701(g) codified the Tufts decision: “[i]n determining the amount of gain or loss (or deemed gain or loss) with respect to any property, the fair market value of such property shall be treated as being not less than the amount of any nonrecourse indebtedness to which such property is subject.”

If a bank holding nonrecourse debt cancels or forecloses on the debt in exchange for the property, the debtor is treated as having sold the property in exchange for the greater of the fair value of the property or the face value of the debt. This is sale gain (Code section 61(a)(3)), not COD (Code section 61(a)(12)).

Note that Code section 7701(g) has no requirement that the debt be included in BASIS (i.e., consistency between basis and amount realized). Thus, even if the nonrecourse proceeds are not included in basis (i.e., because the proceeds were used for other purposes), the entire amount of the nonrecourse debt is included in the amount realized.

Note:
As Justice O’Connor notes in herTufts concurrence, this does create an inequitable result between recourse and nonrecourse debt holders.

Question 11

Chapter 8
Discharge of Indebtedness

Describe Debt not Discharged?

Answer 11

In some situations, when a taxpayer is relieved from his debt obligation, the relief is not DOI. This does not mean that the relief isn’t some other type of income, it’s just not DOI.

No real debt, No discharge — Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990): Zarin was a compulsive gambler. Resorts, a casino, extended credit to him in the form of allowing him to purchase gambling chips in the amount of $3,000,000 in violation of state law. Zarin and Resorts agreed that Zarin would pay $500,000 in satisfaction of the debt, and he did so.
Issue: Did Zarin have $2,500,000 of discharge of debt income (the difference between the loan and the payment)?
Result and rationale: Zarin had no discharge of debt income because there was no debt. Section 108 requires either that (1) the taxpayer be liable for the debt, or (2) the taxpayer hold property subject to the debt. The debt was unenforceable under state law, so Zarin was not liable for the debt. Moreover, because the chips were not property under state law, they were not property securing a debt.

Contested Liability (see Zarin): If a taxpayer, in good faith, disputes the amount of a debt, a subsequent settlement of the dispute will be treated as the amount of debt cognizable for tax purposes.

Question 12

Chapter 8
Discharge of Indebtedness

Elaborate No discharge?

Answer 12

No discharge, cont’d:
Repayment of a taxpayer’s debt by the taxpayer or another person does not create discharge of indebtedness income because the creditor has not taken less than the originally agreed-upon amount. Instead, the repayment by another may be another type of income to the taxpayer, includable in his or her gross income.
No discharge event—No DOI: If the creditor receives what it bargained for, there is no DOI.

Example: Kay borrowed $1,000,000 from Friendly Bank to purchase Pinkacre, an office building. The loan was nonrecourse, which means that Friendly Bank’s only recourse in the event of nonpayment was to foreclose against Pinkacre itself, and Friendly Bank could not proceed against Kay‘s personal assets. The real estate market crashed, Pinkacre’s value dropped to $500,000, and Kay stopped making payments on the debt. The bank took Pinkacre in full satisfaction of the debt. Kay has no discharge of indebtedness because the Bank got exactly what it bargained for—Pinkacre. NOTE: To the extent that Kay’s basis was less than the nonrecourse debt at the time of foreclosure, Kay would have sale gain (Tufts & Code section 7701(g)), but not DOI.

Question 13

Chapter 8
Discharge of Indebtedness

Elaborate foreclosure?

Answer 13

No discharge, cont’d:
Foreclosure: A property foreclosure is treated as a sale for tax purposes regardless of whether the debt is recourse or nonrecourse or whether or not the borrower is the original borrower (see G. Hammel, SCt, 41-1 USTC ¶9169, G.S. Millar, CA-3, 78-2 USTC ¶9154, and A.S. Russo, Dec. 34,379, at ¶29,225.1033, and Rev. Rul. 76-111, ¶29,225.1019).

A foreclosure sale is a realizing event whether it is a judicial or nonjudicial sale (J.C. Chilingirian, CA-6, 90-2 USTC ¶50,569; ¶29,225.1033).

Nonrecourse debt (not bifurcated): The amount realized is not less than the face amount of the debt (greater of fair value of property or face amount of debt)

Recourse debt (bifurcated): The amount realized on the sale is limited to the property’s fair market value. The mortgagor (debtor) may realize debt discharge income if the sale proceeds are less than the amount of debt (Reg. §1.1001-2(a)).

Question 14

Chapter 8
Discharge of Indebtedness

What is DOI Exclusion?

Answer 14

Code section 108 allows an exclusion for discharge of indebtedness income in certain specified circumstances.

The Catch: The exclusion is generally conditioned upon the taxpayer giving up certain tax benefits (really, resulting in deferral not complete exclusion).
Example: Jolene owes Friendly Bank $100,000. Jolene’s assets are $50,000, and her debts total $150,000. In recognition of her dire financial straits, the bank agrees to take $20,000 in satisfaction of the debt. Jolene has discharge of indebtedness income of $80,000, but if she meets one of the conditions of exclusion of §108, she will be able to exclude all or part of the $80,000 of discharge of indebtedness income from her gross income.

Note:
Recognizing whether realized income is DOI is critical because some types of DOI are excludable under Code section 108.
Policy
Various rationales justify this exclusion.
1. Blood from a stone. It is difficult to collect tax from insolvent taxpayers, so deferral of the tax is the best option.
2. Subsidy: For certain types of taxpayers, such as farmers, exclusion or deferral represents a political decision to offer a tax benefit.

Question 15

Chapter 8
Discharge of Indebtedness

What is Code section 108 – Statutory Analysis?

Answer 15

General rule: A taxpayer may exclude from his or her gross income discharge of indebtedness income if any of the following four conditions apply.

Bankruptcy: The discharge occurs in a title 11 (bankruptcy) case. Code §108(a)(1)(A).

Insolvency: The discharge occurs while the taxpayer is insolvent (in this case, the exclusion is limited to the amount of the insolvency). Code §108(a)(1)(B).

Farm debt: The indebtedness discharged is “qualified farm indebtedness.” Code §108(a)(1)(C).

Real property debt: The taxpayer is not a C corporation, and the indebtedness discharged is qualified real property business indebtedness. Code §108(a)(1)(D).

Qualified Personal Residence debt: Code Sec. 108(a)(1)(E) excludes from gross income any income from the discharge (in whole or in part) of “qualified principal residence indebtedness” which occurs between 2007 - 2012.

Some of these provisions are still valid.

Question 16

Chapter 8
Discharge of Indebtedness

What are the Code section 108 definitions?

Answer 16

Indebtedness: In order for §108 to apply, there must be an “indebtedness,” which is defined as a debt for which the taxpayer is liable or a debt secured by the taxpayer’s property. Code §108(d)(1). See Zarin v.Commissioner.

Discharge of indebtedness income: In order for §108 to potentially apply there must be discharge of indebtedness income.
Here is were it is critical to distinguish between DOI and other types of income.

Insolvency: A taxpayer is insolvent if, and to the extent that, his or her liabilities exceed the fair market value of his or her assets. Code section 108(d)(3).
Insolvency is determined immediately prior to discharge. IRC §108(d)(3).
Note that insolvency and bankruptcy are different

Qualified farm indebtedness: This definition is quite technical, but generally means commercial or governmental debt incurred by a person whose primary business is farming. IRC §108(g)(2).

Qualified real property business indebtedness: This definition is also technical, but generally means debt incurred in connection with real property used in a trade or business and secured by that property. Code section 108(g)(3)(C).

Question 17

Chapter 8
Discharge of Indebtedness

What are the Code section 108 Qualified principal residence indebtedness ?

Answer 17

Qualified principal residence indebtedness is acquisition indebtedness, limited to $2 million dollar ($1 million for married filing separate) (Code Sec. 108(h)(2)).
An individual’s acquisition indebtedness is indebtedness with respect to that individual’s principal residence if it is incurred in the acquisition, construction, or substantial improvement of such residence and is secured by the residence.

Qualified principal residence interest also includes refinancing of such indebtedness to the extent that the amount of the refinancing does not exceed the amount of the refinanced indebtedness.

Principal residence is defined at Code section 121.

The exclusion does not apply to a debtor in a Title 11 bankruptcy case. Rather, the exclusion under Code Sec. 108(a)(1)(A) (exclusion due to bankruptcy) applies. However, the exclusion of debt discharged on a principal residence applies to insolvent taxpayers not involved in Title 11 bankruptcy cases unless the taxpayer elects to have the exclusion of Code Sec. 108(a)(1)(B) (exclusion due to insolvency) apply (Code Sec. 108(a)(2)(C)(2)).

Note:
As discussed below, if the insolvency exclusion is used, a taxpayers tax attributes may be lost. Thus, if QPR debt is less than the limitations $2 million or $1 million, it is preferable to use this exclusion. If the insolvency is more than the QPR limit, it is preferable to elect the insolvency exclusion.

Question 18

Chapter 8
Discharge of Indebtedness

What are the Code section 108 The Catch?

Answer 18

The Catch: The exclusion from gross income is not “free.” For each dollar of exclusion claimed by the taxpayer because of any exclusion other than real property business indebtedness and qualified principal residence indebtedness, the taxpayer must also write down its “tax attributes” or reduce the basis of his or her depreciable property. Code §108(b)(1).

Effect: Deferral. Although §108 will protect the taxpayer from the inclusion of discharge of debt income in gross income, the taxpayer will experience a burden in the future—by having fewer tax benefits to enjoy or having property with a lower basis for depreciation and a larger gain on sale.

Question 19

Chapter 8
Discharge of Indebtedness

What are the Code section 108 The Catch?

Answer 19

Tax attributes: Tax attributes are reduced in this order (Code section 108(b)(1), (2)):
net operating losses and carryovers,
certain tax credits,
capital loss carryovers,
passive activity loss carryovers, and
foreign tax credit carryovers.

Basis reduction: The taxpayer may elect in certain cases to apply the exclusion amount to reduce the basis of his or her depreciable property, up to the basis of that property. Code §§108(b)(5)(A) & 1017.

Example: Kathy has discharge of indebtedness income of $80,000, which is discharged in a Title 11 case. She also has a net operating loss carryforward of $50,000 and depreciable property with a basis of $40,000. Kathy elects to apply the exclusion amount of $80,000 first to the basis of her depreciable property ($40,000), and thereafter she reduces her net operating loss carryover from $50,000 to $10,000.

Question 20

Chapter 8
Discharge of Indebtedness

What are the Code section 108 Issues?

Answer 20

Purchase price adjustment: A discharge of debt will be treated as a purchase price adjustment (which has no tax consequences) if the seller of property reduces the debt incurred to acquire the property (i.e., purchase money debt), and the reduction does not occur in a Title 11 case or when the purchaser is insolvent. Code §108(e)(5).

Student Loans: Gross income does not include any discharge of a student loan if the discharge occurs because the student works for a certain period of time for a nonprofit or governmental organization. IRC §108(f)(1).

Stock for debt: If a corporation issues stock to a creditor in satisfaction of the debt it owes to that creditor, the corporation is considered to have satisfied the debt with an amount of money equal to the fair market value of the stock. This may lead to discharge of indebtedness income, which in turn may (or may not) be excluded under §108. Code section §108(e)(8).

Qualified farm indebtedness: The total qualified farm indebtedness that can be excluded is limited to an amount roughly equal to three times the taxpayer’s tax attributes plus the bases of assets. IRC §108(g)(3)(A), (B).

Note:
Example: Larry purchases a backhoe for $35,000, giving the seller $5,000 in cash and a promissory note for $30,000. Later, the purchaser agrees to reduce the amount of the note to $20,000, in light of difficulties Larry is having with the equipment. Assuming Larry is not insolvent and is not participating in a bankruptcy proceeding, the $10,000 reduction (which would otherwise be discharge of indebtedness income) will be treated as a reduction of the original purchase price from $35,000 to $25,000. Therefore, Larry will not have any discharge of indebtedness income.

Example: Mary incurs $40,000 in student loans to attend medical school. The lender offers a program under which, if she works for five years in a publicly funded poverty medical program, $25,000 of her loans will be discharged. Mary works for five years in a qualifying program and receives the benefit of the $25,000 discharge. This discharge of indebtedness income is not included in Mary’s gross income.

Example: Nota Bene Corporation owes $50,000 to a creditor. Being in dire financial straits, Nota Bene issues common stock worth $25,000 to the creditor, who accepts it in full satisfaction of the debt. This transaction results in $25,000 of discharge of indebtedness income to Nota Bene Corporation (the difference between the face amount of the debt and the fair market value of the stock accepted in satisfaction of the debt). If Nota Bene is insolvent or qualifies under any of the other exclusions, it may exclude all or a portion of the income from gross income. Otherwise, Nota Bene must include the income in its gross income.

Question 21

Chapter 9
Damages

Describe damages of Raytheon?

Answer 21

Amounts received pursuant to a judgment or a settlement in cases where the taxpayer’s lawsuit asserts a non-personal injury (i.e., a business injury) are includible in gross income. See, e.g., Treas. Reg. section 1.61-14(a), specifically mentioning punitive damages (gross income equivalent to windfall gains and treasure trove).

A settlement award is properly includable in the computation of gross income where the damages represent compensation for lost profits. (Raytheon Production Corporation v. Commissioner)
Note: What was really at issue in Raytheon wasn’t whether the damages were income, but whether the damages were fully included as lost profits, or represented a return of capital (excludable up to basis & taxable in excess of basis). In Raytheon, the court found that the damages pertained to damaged goodwill and that the excess of damages over basis were includible as income.

The million dollar question is….In lieu of what were the damages paid?

Question 22

Chapter 9
Damages

Describe Damages and Other Recoveries for Personal Injuries (§104)?

Answer 22

Section 104(a) excludes from gross income amounts received as compensation for personal physical injury or sickness.

Code section 104
General rule: A taxpayer may exclude from his or her gross income amounts received for personal physical injury or physical sickness in the form of workers‘ compensation payments, damages received, certain amounts received from health insurance, and certain other personal injury payments not commonly encountered. Code section 104(a).

Damages—Method of payment: The exclusion applies whether the damages are received in a lump sum or as periodic payments. Code §104(a).

Damages—Suit or settlement: Damages may be received either as a judgment or in settlement of a claim. Code §104(a)(2). If in settlement, the proper allocation of damages among claims and types of damages is a question of fact. Some may be excludible others may not be (e.g., punitive damages).

Disability insurance payments: Amounts received through disability insurance payments are excluded from gross income if the premiums were either paid by the insured person or were paid by the employer but included in the gross income of the insured employee. If the premiums were not included in employee income, the payments are includible (§104(a)(3)).

Note:
The following rationales have been offered for this exclusion.
1. No income: Because the taxpayer is merely placed back in his or her original (undamaged) state, the taxpayer has no benefit and therefore no income from the transaction.
2. Measurement: Even if the taxpayer has some amount of income, it is too difficult to measure.
3. Adding insult to injury: It would be cruel to an injured taxpayer to include these amounts in income.

Question 23

Chapter 9
Damages

Describe Personal injury or sickness

Answer 23

Personal injury or sickness: Only amounts received on account of “personal physical injuries” or “physical sickness” are excludable. Code §104(a)(2). Business injuries, and personal nonphysical injuries, such as discrimination, are not excluded.
Special rules and exceptions:
Previously deducted medical expenses: The exclusion does not apply to amounts the taxpayer has deducted as medical expenses under §213. Code §104(a).
Example: Ian slipped on his neighbor’s steps and hurt his back. In the year of his injury he incurs medical expenses, and he properly claims $2,000 as a deduction on that year’s tax return. In the next year he receives $5,000 in payments from his neighbor’s insurance company. Assuming the entire amount is compensation for personal physical injuries, only $3,000 is excludable from gross income, as the other $2,000 is attributable to previously deducted medical expenses and must be included in gross income.

Question 24

Chapter 9
Damages

Describe Tax Exempt Benefits from Accident & Health Plans (§105)

Answer 24

INCLUSION: The general rule of Code Sec. 105 requires the inclusion in income of amounts received by an employee under employer-financed accident and health plans. These generally represent lost wages (ordinary income).
EXCLUSION: Amounts received as reimbursements for medical care are excludable from gross income (Code Sec. 105(b)).

Similarly, payments for permanent injury or loss of bodily function are excludable from gross income, provided the amount of the payments is determined with reference to the nature of the illness or injury and not determined with reference to the recipient’s period of service or wages lost through absence from work (Code Sec. 105(c)).

INCLUSION: Amounts received by an employee through accident and health insurance that are not reimbursements of medical expenses, but are instead payments for personal injuries or sickness, generally are includible in gross income if the amounts:

(1) are attributable to contributions by the employer that were not includible in the employee's gross income, or
(2) are paid directly by the employer (Code Sec. 104(a)(3)).

Employees generally pay taxes on these amounts because they represent  taxable wages lost due to accident or sickness.

Question 25

Chapter 9
Damages

Describe Employer Contributions to Accident and Health Plans (§106)

Answer 25

Contributions by an employer to accident and health plans, to provide coverage for employees in the event of personal injury or sickness to the employee, his spouse or his dependents, are not taxable to the employees (Reg. §1.106-1).

Special rules apply to contributions to Archer medical savings accounts (MSAs) (Code Sec. 106(b)) and Health Savings Accounts (HSAs).

The exclusion is applicable whether the employer’s contribution is made by payment of insurance premiums or by some other means, such as a contribution to an independent fund, and whether retired as well as active employees are covered (Rev. Rul. 62-199).

If health and accident insurance is purchased, the exclusion will apply regardless of whether or not a group policy or an individual policy is involved. However, if the policy purchased provides other benefits besides health and accident benefits, then only that portion of the employer’s contribution allocable to the accident and health benefits is excludable under Code Sec. 106.

Gross income does include long-term care benefits provided through flexible spending arrangements (Code Sec. 106(c)).

Question 26

Chapter 11A
Sale of a Principal Residence

Describe Gain on the Sale of a Principal Residence

Answer 26

Under Code section 121, a taxpayer may exclude from gross income up to $250,000 ($500,000 for joint filers) of the gain on the sale of his or her principal residence.

Example: Carla owned a home, her principal residence, in which she has a basis of $40,000. Carla sold her home for $190,000. Carla’s gain on the sale is $150,000 ($190,000−$40,000). She may generally exclude all of this gain from gross income pursuant to §121.

Code section 121
General rule: A taxpayer may exclude up to $250,000 ($500,000 for joint filers) of gain on the sale of a principal residence if the following two conditions are met.
Principal residence: The taxpayer must have owned and used the property as a principal residence for a period aggregating two or more years during the five-year period ending on the date of the sale or exchange. IRC §121(a).
Once every two years: A taxpayer may generally only take advantage of this provision once every two years.

Note:
Policy
Section 121 is one of several Code provisions favoring investment in real estate, particularly homes. As a practical matter, §121 will result in most sales of taxpayers’ principal residences being tax free.

Question 27

Chapter 11A
Sale of a Principal Residence

What is Principal Residence?

Answer 27

Definitions:
Principal residence: The principal residence is the residence where the taxpayer actually lives, based on all the facts and circumstances of the situation. A principal residence can be a nontraditional dwelling, such as a houseboat, a recreational vehicle, or stock in a tenant cooperative. Reg. §1.121-1(b).

Ownership and use: Ownership and use may be satisfied with nonconcurrent periods of time. For the use requirement, occupancy of the dwelling is required, but short absences, such as for vacation or illness, do not interrupt a period of use. Reg. §1.121-1(c). If a dwelling is used partly for business and partly for residence, only the part attributable to the residence use is eligible for the §121 exclusion. Reg. §1.121-1(e).

Example: Charles lived in a condo that he rented from 2012 through 2015. On January 1, 2016, he purchased this condo. On February 1, 2016, Charles moved into his daughter’s home. On March 1, 2018, while still living in his daughter’s home, Charles sold his condo. The §121 exclusion will apply to gain from the sale because Charles owned the condo for at least two years out of the five years preceding the sale (from January 1, 2016 until March 1, 2018) and he used the condo as his principal residence for at least two years during the five-year period preceding the sale (from February 1, 2014 until February 1, 2016).

Note:
When the taxpayer has more than one property that he or she uses as a residence, the property that the taxpayer uses the majority of the time during the year will be treated as the taxpayer’s principal residence for that year. Other factors taken into account in determining the taxpayer’s principal residence include: the taxpayer’s place of employment; the principal place where the taxpayer’s family lives; the address used by the taxpayer on tax returns, driver’s license, automobile registration, and voter registration; the mailing address used by the taxpayer for bills and correspondence; the location of the taxpayer’s banks; and the location of religious organizations and recreational clubs with which the taxpayer is affiliated (Reg. §1.121-1(b)).

Question 28

Chapter 11A
Principal Residence

What are the Special rules and exceptions for Principal Residence?

Answer 28

Special rules and exceptions
Reduced exclusion: When a taxpayer cannot satisfy the use/ownership test, or needs to use the exclusion more than once in a two-year period, special rules may apply to allow a reduced exclusion. The taxpayer’s need to sell must arise from a change in place of employment, health, or other unforeseen circumstances. If so, the maximum exclusion is determined by multiplying the maximum gain ($250,000, or $500,000 for joint filers) by a fraction, the numerator of which is the amount of time the taxpayer did own or use the property, or the period of time since the last §121 sale, and the denominator is two years (expressed as days or months).

Example: Angus who files as a single taxpayer, sold a home on January 1, 2006, excluding $250,000 of gain under §121. He purchased another home, and because of serious health problems, was forced to sell it on March 1, 2007. He realized $200,000 of gain on the second sale. To determine the maximum exclusion on the second sale, Angus multiplies $250,000 by a fraction, the numerator of which is the total number of days he owned the home (365+ 59 = 424) and the denominator of which is 730 (2×365). 250,000 × 424/730=$145,205. Because his realized gain ($200,000) is greater than the maximum exclusion, Angus is limited to excluding $145,205 of his gain, and he must recognize $54,795. Note: if Angus’s realized gain had been less than the maximum exclusion, all of the gain would have been excluded.

Example:
Example: Angel, who files as a single taxpayer, purchases her first house that she uses as her principal residence. Twelve months after the purchase, Angel sells the house due to a change in place of her employment. Angel is eligible to exclude up to $125,000 of the gain from the sale of her house (12/24×$250,000).

Question 29

Chapter 11A
Principal Residence

What are the Special rules and exceptions for Principal Residence for Spouses?

Answer 29

Special rules and exceptions, cont’d:
Spouses: A husband and wife will meet the requirements of §121 if both or either of them meet the ownership and use tests, and neither of them has used the §121 exclusion in the past two years. If they don’t meet this test, their maximum exclusion will be the sum of their individual exclusions. Reg. §1.121-2(b)(1), (2).

Example: During 2015, newly married taxpayers James and Anne each sell a residence that each had separately owned and used as a principal residence before their marriage. Each spouse meets the ownership and use tests for his or her respective residence. Neither spouse meets the use requirement for the other spouse’s residence. James and Anne file a joint return for the year of the sales. The gain realized from the sale of James’ residence is $200,000. The gain realized from the sale of Anne’s residence is $300,000. Because the ownership and use requirements are met for each residence by each respective spouse, James and Anne are eligible to exclude up to $250,000 of gain from the sale of each of their residences. However, Anne may not use James’ unused exclusion to exclude gain in excess of her exclusion amount. Therefore, James and Anne must recognize $50,000 of the gain realized on the sale of Anne’s residence.

Question 30

Chapter 11A
Principal Residence

What are the Special rules and exceptions for Principal Residence for Disabled taxpayer?

Answer 30

Special rules and exceptions, cont’d:
Disabled taxpayer: An elderly or disabled taxpayer who moves to an assisted care facility may have difficulty meeting the use requirement. A special rule allows such taxpayers to claim the exclusion if the taxpayer uses the property as a residence for at least one year out of the five ending on the date of sale. Code §121(d)(7).
Estates and trusts: An estate or heir of a decedent, or certain trusts of the decedent, may take advantage of the exclusion of §121. These taxpayers may add the period of time the property was owned/used by the decedent to their ownership/use period to meet the statutory requirements. Code §121(d)(9).
Nonqualified Use (Rental): Where the property is used for some time as rental property (e.g., “nonqualified use”), the amount of the exclusion may be reduced both by the amount of time the property was rented and by the amount by which gain is due to the taxpayer having taken depreciation deductions.

Note:
Assume that an individual buys a property on January 1, 2015, for $400,000 and uses it as rental property for two years, claiming $20,000 of depreciation deductions. On January 1, 2017, the taxpayer converts the property to his principal residence. The taxpayer moves out on January 13, 2019, and sells the property for $700,000 on January 1, 2020. The $20,000 gain attributable to the depreciation deductions is included in income. Of the remaining $300,000 gain, 40% (two years divided by five years), or $120,000, is allocated to nonqualified use and is not eligible for the exclusion. Since the remaining gain of $180,000 is less than the maximum gain of $250,000 that may be excluded, the remaining gain of $180,000 is excluded from gross income