Discharged Indebtedness Is Income And Is Taxable

During their marriage, the Stevenses purchased a dilapidated investment property in Chicago. (Investors are making similar purchases in Los Angeles, Ventura, Santa Barbara and Orange Counties, California, all of which may lead to a similar outcome as occurred in Chicago.) The couple borrowed $256,000 for the purchase of the property, only to realize shortly thereafter that not only did they not like each other, but they also could not make the payments. Rather than falling into foreclosure and ruining their credit, they entered into a short-sale agreement with the lender and, in 2003, found a buyer willing to purchase the property for $200,000.

Even though the lender had informed the Stevenses that they would report the discharge of indebtedness to the Internal Revenue Service and had mailed separate letters to Mr. Stevens and his ex-wife informing them of the exact dollar amount, neither reported the discharged indebtedness as income on their tax return.

Generally, a taxpayer must include income from the discharge of indebtedness under Section 61(a)(12) of the income tax regulations. However, there are exceptions to this rule. Section 108(a) provides that a taxpayer may exclude income from the discharge of indebtedness if the discharge occurs in a bankruptcy case, or when the taxpayer is insolvent, or if the indebtedness is qualified farm or business real estate debt.

The IRS determined and the Tax Court agreed that in addition to the tax deficiency, a 20 percent accuracy-related penalty under Code Section 6662(a) to be applicable because Mr. Stevens understated his income tax by $21,323 on his return. Because Mr. Stevens’ understatement of tax was greater than 10 percent of the tax required to be shown on the return or $5,000, the understatement was a substantial understatement of income tax pursuant to Code Section 6662(d)(1)(A). Mr. Stevens argued that he should not be held liable for the penalty because of his reliance on Ms. Stevens to report all of the relief from indebtedness income (Form 1099-C income) from the cancellation of indebtedness on her income tax return since both Forms 1099-C were mailed to her address.

The argument that Mr. Stevens had relied on his ex-wife to report the income from the indebtedness did not hold water with the Court.

The Tax Court concluded that Mr. Stevens failed to show that his reliance on Ms. Stevens’ reporting the full amount of income and paying the requisite tax on that income was reasonable. Mr. Stevens admitted that he knew Ms. Stevens had received both Forms 1099-C and that the amount at issue, $74,494.96, should have been reported–either in full or in part–on one of or both of the Stevenses’ returns for that year. The record is silent as to any facts that would have led to a reasonable assumption on the part of Mr. Stevens that he was not responsible for reporting the amount contained on the Form 1099-C in income.

The lesson, of course, is not to trust your ex-spouse to pay your taxes. The Court did state that Mr. Stevens could look to civil remedy against his ex-wife, as they did own the property as joint tenants and should be equally responsible for the declaration of the income tax.

You can read the entire Court decision here.

Need help negotiating with the IRS the amount of tax to be paid on relief from indebtedness income? Call tax attorney Mitchell A. Port at (310) 559-5259 for tax help.