Please help me analyze this. (long)

[WhiteOleander]

Ok, had a new client come in for a consult regarding the 2005 return. Reported wages, sch A. Nothing unusual.

He received a letter from IRS regarding cancelled debt for 2005.

This all started over property he owned beginning approx 1991. It was a RV sales and repair business. He ran the business as a S-Corp. But, he personally owned the property and buildings in his name. He rented the facilities to the S-Corp.

He eventually closed the S-Corp. Sold the property on an installment sale. Moved to a different state. However, the property sale never went through. Never received any money. He could not pay the bank. Bank threatened to foreclose. But, never actually did.

Bank A sold the note to Bank B at a discount. Then Bank A issued a 1099C to T/P for the amount they dicounted the note to Bank B.

IRS raises it's ugly head and wants tax on cancelled debt. But, T/P fought them. Was headed to tax court. IRS backs down and agrees the bank did not forgive debt to him if they sold the note at a discount. So, case closed.

So, now he hears from Bank B. They tell him that they now have the note. And if he will quit claim the property to them, they will release him from the debt.

So, T/P feels this is a sale and wants to amend the '05 return and report the loss. His basis is approx 180,000. The debt on the property when the quit claim was done was 107,000.

I keep thinking that this is actually forgiveness of the debt. Since he didn't actually pay the money back. But, I can see where the quit claim could be seen as a sale.

Is it a sale?
Thanks.

[Harvey Lucas]

Sounds like a sale to me

My vote is that he sold the property to the bank for the balance due on the note.

Harvey Lucas

[WhiteOleander]

Yes, it does look like a sale. I guess what stumps me is that the amount originally borrowed was not paid back. Since the note was bought at a discount, he only paid back the 107,000.

Bank A had issued the 1099C for about 67000. So, T/P did not have to repay that or include it into income. T/P did not have to account for the original principal of the note.

But, maybe I'm reading too much into it. I just don't see that he has a loss with the 67000 still not paid.

[Harvey Lucas]

Adjust his basis

Sounds like the conservative approach is to adjust his original basis for the 67000 he did not have to pay.

You are right, it would be dificult to support a loss deduction that included this $67000 amount.

[Bees Knees]

It may not have been forgiveness of debt when Bank A sold the note to Bank B at a discount because nobody forgave any debt on that transaction. The forgiveness of debt occurred when the taxpayer quit claimed the deed to Bank B and Bank B says you don't need to pay us back anything. The FULL forgiveness of debt from the original note from Bank A is reported as gross proceeds on the sale.

Taxpayer reports a taxable sale on the transaction for the entire amount of debt forgiven (the note discount from Bank A, plus the remaining debt forgiven by Bank B). The taxpayer can then use his $180,000 basis to offset the amount of debt forgiven.

Example: Original purchase price = $180,000, no money down. Everything financed.

Taxpayer pays back $20,000 of principal.

Taxpayer stops making payments.

Bank A takes the $160,000 balance and sells the note to Bank B for $100,000.

Bank B tells taxpayer they will ignore the note if he quit claims the property to Bank B.

Debt forgiveness income = $160,000 (Bank A discount of $60,000 + $100,000 note from Bank B).

Basis in property equals $180,000 (original purchase price).

Loss on transaction = $20,000 ($160,000 debt forgiven minus $180,000 cost basis).

The $20,000 total loss represents the cash the taxpayer actually paid out of pocket during the time he was making principal payments on the loan. In other words, whatever is out of pocket (not counting interest), he gets to claim as a loss.

[WhiteOleander]

Thanks Bees. That makes sense. Now all I have to do is make the client understand. So many do not grasp the concept of debt forgivness.