Basis reduction required in year of debt discharge

The Tax Court held that the basis adjustment relating to the discharge of certain qualified real property business indebtedness (QRPBI) occurs in the year the property is sold and not in the subsequent year, as is the case for other types of discharges.

Facts: Richard Hussey purchased 27 investment properties in 2009. To do so, he assumed approximately $1.7 million of outstanding loans. He sold 16 of the properties in 2012 and another seven in 2013, all but one at a loss. Hussey's debt was modified following the 2012 sales, and he received a Form 1099 - C , Cancellation of Debt, for each property he sold at a loss in 2012. The total amount of debt discharged indicated on the Forms 1099 - C was $754,054. After the 2013 sales, Hussey asked the bank for another modification of the remaining debt. The bank charged off $529,665 and indicated in its records that any payments received up to that amount would be posted as a loan loss reserve recovery. The bank did not issue any Forms 1099 - C to Hussey for 2013.

Hussey's accountant prepared and filed his Form 1040, U.S. Individual Income Tax Return, for 2012. Form 4797, Sales of Business Property, showed that the properties had been sold at a gain of approximately $84,000. Hussey sought the advice of his longtime financial adviser because he believed his 2012 return was incorrect. Hussey's financial adviser referred Hussey to a CPA at a large accounting firm, and, due to the complexity of Hussey's Form 1040, the CPA recommended a tax attorney at a law firm. The attorney, who had been in practice for over 30 years, prepared an amended Form 1040 for 2012 and also prepared Hussey's 2013 and 2014 returns. The Form 4797 attached to the amended 2012 return showed a loss totaling $613,263. The return also contained Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), showing that Hussey excluded income relating to the discharge of QRPBI. Hussey's 2013 return showed a loss of $437,650 relating to the sale of six investment properties, and his 2014 return showed a net operating loss carryforward from 2013 of $423,431. In 2018, the IRS issued a notice of deficiency for 2013 and 2014, as well as accuracy - related penalties totaling nearly $19,000, due to its disallowance of the loss deductions on Form 4797.

Law and regulations: The discharge of indebtedness generally results in an inclusion of gross income to the taxpayer. However, Sec. 108(a)(1)(D) provides an exclusion for the discharge of QRPBI. The amount that can be excluded may not exceed (1) the QRPBI's outstanding principal amount (immediately before the discharge) over (2) the property's fair market value less any other QRPBI outstanding principal secured by the property (Sec. 108(c)(2)(A)). In addition, the discharge must satisfy a basis - aggregation rule. Sec. 108(c)(2)(B) states that the amount excluded as QRPBI cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately preceding the discharge.

The exclusion for discharge of QRPBI also results in a basis adjustment. Sec. 108(c)(1) requires the basis of the taxpayer's depreciable real property to be reduced by the amount excluded from income as QRPBI under Sec. 108(a)(1)(D). The timing rules relating to such basis adjustment are found in Sec. 1017. Sec. 1017(a) provides the general rule that basis adjustments resulting from the discharge of QRPBI are made in the tax year after the tax year of discharge. However, subsection (b) includes additional rules relating to the discharge of QRPBI, one of which specifically deals with the disposition of an asset that was considered for the basis aggregation rule of Sec. 108(c)(2)(B). Sec. 1017(b)(3)(F)(iii) states that if property taken into account under Sec. 108(c)(2)(B) is disposed of prior to the time provided in Sec. 1017(a), the basis reduction shall be made immediately prior to the disposition. Therefore, if such property is disposed of in the year the QRPBI is discharged, the basis adjustment must be made in the year of the discharge, as opposed to the subsequent year.

Issues: The parties agreed that Hussey was entitled to an exclusion for the discharge of QRPBI under Sec. 108(a)(1)(D) in 2012. They also agreed that the amount discharged was less than the aggregate bases of the depreciable real properties Hussey held at the time of the discharge and that he was required to reduce his bases in such properties. The parties disagreed, however, as to the timing of the basis adjustment. Hussey contended that under Sec. 1017(a), the basis adjustment should be made in 2013, the year after the discharge. According to Hussey, the aggregate bases of the properties he continued to own after the sales in 2012 were greater than the amount of QRPBI discharged in 2012, and therefore the bases of those assets could be reduced in 2013. The IRS argued that the basis adjustment should be made in 2012, immediately before the dispositions, in accordance with Sec. 1017(b)(3)(F)(iii).

Holding: Resolution of the dispute turned on whether the property sold in 2012 was taken into account under Sec. 108(c)(2)(B), thereby triggering Sec. 1017(b)(3)(F)(iii). Although the Tax Court did not find the language of the Code ambiguous, it turned to the legislative history of the relevant provisions, which were enacted in 1993. The goal was to provide relief through a basis adjustment to taxpayers who owned certain real estate that had significantly declined in value. Rather than an immediate inclusion from the discharge of indebtedness, the basis adjustment would result in the deferral of that income until the property was disposed of, but "[g]enerally, that deferral should not extend beyond the period that the taxpayer owns the property" (quoting H.R. Rep't No. 111, 103d Cong., 1st Sess. 593 (1993)).

The Tax Court found the legislative history language clear that if property is sold in the same year as the discharge, the basis adjustment must be made in the year property is sold. According to the Tax Court, the specific properties that are considered to be taken into account for purposes of Sec. 108(c)(2)(B) are fixed at the time the debt is discharged. The disposition of one of those properties in the year of discharge results in an immediate basis adjustment, regardless of the bases in the properties not sold. As a result, under Sec. 1017(b)(3)(F)(iii), Hussey was required to reduce the bases of properties sold in 2012, the year his QRPBI was discharged. Since the basis reduction should have occurred in 2012, and not 2013, the deductions claimed on the 2013 Form 4797 were improper, as were the losses carried forward from 2013 to 2014.

The Tax Court also held that Hussey did not have any debt discharged in 2013 because he did not receive a Form 1099 - C from the bank. In addition, although the bank "charged off" the amount of the debt in 2013, it also created a loss reserve account for the amount, indicating that it did not intend to discharge the debt.

Hussey was found not liable for an accuracy - related penalty because he had reasonable cause and acted in good faith. Hussey took steps to ensure his returns were correct and relied on a qualified tax firm to prepare his returns.

— By Laura Lee Mannino, CPA, J.D., LL.M., associate professor of taxation, St. John's University, Queens, N.Y.