Bankruptcy Tax Guide, Basis Reduction

If any amount of the debt cancellation is used to reduce the basis of assets as discussed under Reduction of Tax Attributes, the following rules apply to the extent indicated.

When to make the basis reduction. Make the reduction in basis at the beginning of the tax year following the tax year of the debt cancellation. The reduction applies to property held at that time. See section 1.1017-1 of the Income Tax Regulations for more information.

Bankruptcy and insolvency reduction limit. The reduction in basis because of canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later.

Exempt property under title 11. If debt is canceled in a bankruptcy case under title 11 of the United States Code, make no reduction in basis for property that the debtor treats as exempt property under section 522 of title 11.

Election to reduce basis first. You (the estate in the case of an individual bankruptcy under chapter 7 or 11) may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.

Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. You may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. You must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, you can only revoke it with IRS approval. However, if you establish reasonable cause, you may make the choice with an amended return or claim for refund or credit.

Making elections. Make the election to reduce the basis of depreciable property before reducing other tax attributes as well as the election to treat real property inventory as depreciable property, on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

Recapture of basis reductions. If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain that is from this basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of this basis reduction as a depreciation deduction and by treating any such basis reduced property that is not already either section 1245 or section 1250 property as section 1245 property. In the case of section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation. Sections 1245 and 1250 and the recapture of gain as ordinary income are explained in chapter 4, Dispositions of Depreciable Property, in Publication 544, Sales and Other Dispositions of Assets.

Partnerships
If a partnership's debt is canceled because of bankruptcy or insolvency, the rules for the exclusion of the canceled amount from gross income and for tax attribute reduction are applied at the individual partner level. Thus, each partner's share of debt cancellation income must be reported on the partner's return unless the partner meets the bankruptcy or insolvency exclusions explained earlier. Then all choices, such as the choices to reduce the basis of depreciable property before reducing other tax attributes, to treat real property inventory as depreciable property, and to end the tax year on the day before filing the bankruptcy case, must be made by the individual partners, not the partnership.

Depreciable property. For purposes of reducing the basis of depreciable property in attribute reduction, a partner treats his or her partnership interest as depreciable property to the extent of the partner's proportionate interest in the partnership's depreciable property. This applies only if the partnership makes a corresponding reduction in the partnership's basis in its depreciable property with respect to the partner.

Partner's basis In partnership. The allocation of an amount of debt cancellation income to a partner results in that partner's basis in the partnership being increased by that amount. At the same time, the reduction in the partner's share of partnership liabilities caused by the debt cancellation results in a deemed distribution, in turn resulting in a reduction of the partner's basis in the partnership. These basis adjustments are separate from any basis reduction under the attribute-reduction rules described earlier.

Corporations
Corporations in a bankruptcy proceeding or insolvency generally follow the same rules for debt cancellation and reduction of tax attributes as an individual or individual bankruptcy estate would follow.

Stock for Debt Exchange
If a corporation transfers its stock in satisfaction of indebtedness and the fair market value of its stock is less than the indebtedness it owes, the corporation has income (to the extent of the difference) from the cancellation of indebtedness. After 1994, a corporation can exclude all or a portion of the income created by the stock for debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent. However, the corporation must reduce its tax attributes (to the extent it has any) by the amount of excluded income.

Stock for debt exception. The stock for debt exception was repealed for transfers made after 1994 unless the corporation filed for bankruptcy (or similar court proceeding) before 1994. Generally, before 1995, a corporation did not realize income because of such stock for debt exchanges if it was in bankruptcy or to the extent it was insolvent. Consequently, there was no gross income to exclude and no reduction of its tax attributes was necessary. The principal difference between the stock for debt exception and the stock for debt exchange is that the corporation does not reduce its tax attributes under the stock for debt exception.

Earnings and profits
The earnings and profits of a corporation do not include income from the discharge of indebtedness to the extent of the amount applied to reduce the basis of the corporation's property as explained earlier. Otherwise, discharge of indebtedness income, including amounts excluded from gross income, increases the earnings and profits of the corporation (or reduces a deficit in earnings and profits).

If there is a deficit in the corporation's earnings and profits and the interest of any shareholder of the corporation is terminated or extinguished in a title 11 or similar case (defined earlier), the deficit must be reduced by an amount equal to the paid-in capital allocable to the shareholder's terminated or extinguished interest.

S Corporations
For S corporations, the rules for excluding income from debt cancellation because of bankruptcy or insolvency apply at the corporate level.

Net operating losses. A loss or deduction that is disallowed for the tax year of the debt cancellation because it exceeds the shareholders' basis in the corporation's stock and debt is treated as a net operating loss for that tax year in making the required reduction of tax attributes for the amount of the canceled debt.

Debt Cancellation

Information courtesy of the Internal Revenue Service.