Generally, if you satisfy a debt for less than the face amount, you have cancellation of debt (COD) income and COD income is taxable. There are several exceptions to this rule.
One is if you're insolvent at the time you receive the income. The term insolvent means the excess of liabilities over the fair market value of assets. In Bernard R. Shepherd et ux. (T.C. Memo. 2012-212) the taxpayers settled a credit card debt for $4,412 less than the amount due and received a Form 1099-C, Cancellation of Debt for that amount. The taxpayers claimed they were insolvent at the time the debt was canceled.
The IRS only disputed the fair market value claimed for the taxpayers' principal residence and their beach house. The taxpayers entered into a settlement with the city regarding the value of the beach house for property tax purposes and cited that as a basis, along with comparable sales the taxpayers had assembled in grieving the valuation. The Court noted that the comparable sales were at least two years after the discharge of the debt, and were not backed up by details and valuation methodology. As to the settlement with the city, the Court noted that it has previously that a value placed upon property for the purpose of local taxation, unsupported by other evidence, cannot be accepted as determinative of fair market value for Federal income tax purposes in the absence of evidence of the method used in arriving at that valuation. The Court found the taxpayers also failed to show the fair market value of their principal residence.
The Tax Court found the evidence the taxpayers provided for the FMV of the two residences did not meet the required burden of proof. Sec. 108(d)(3) requires the FMV of the taxpayer’s assets to be determined “immediately before discharge.” The taxpayers provided a stipulated settlement of the value of the vacation home for local real estate tax purposes of $380,000 for 2010, two years after the discharge. Besides not being a value contemporaneous with the discharge, the Tax Court noted that values for real estate tax purposes are not persuasive without other evidence corroborating them.
An "appraisal" by a bank the taxpayers cited was as of 2011, some three years after the discharge of the debt. The Court also discounted the value of the assessment of the property for the tax bill. The Court held the taxpayers did not meet their burden of proof in showing they were insolvent at the time of the discharge of the debt.
A timely appraisal would have caused the canceled debt to be non-taxable.
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