Tax Consequences When Debt is Discharged
The drop in crop prices in recent months has introduced financial strain for some producers. Bankruptcy practitioners that we know are reporting an increase in clients dealing with debt workouts and other bankruptcy-related concerns. We will produce a technical article for TaxPlace on the debt discharge rules for farmers, but below is an outline of the basics.
An important part of debt resolution is the income tax consequences to the debtor. Except for installment land contracts and CCC loans, most farm debt is recourse debt. That means that the collateral stands as security on the loan. If the collateral is insufficient, the debtor is personally liable on the obligation and the debtor's non-exempt assets are reachable to satisfy any deficiency. So, when the debtor gives up property, the income tax consequences involve a two-step process. Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt. There is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. Then, the difference between fair market value and the income tax basis is gain or loss. Finally, if the indebtedness exceeds the property's fair market value, the difference is discharge of indebtedness income.
There are several relief provisions that a debtor may be able to use to avoid the general rule that discharge of indebtedness amounts are income, but a big one for farmers is the rule for “qualified farm indebtedness.” For all debtors other than farmers, once solvency is reached there is income from discharge of indebtedness. For solvent farm debtors, however, the discharge of indebtedness arising from an agreement between someone engaged in the trade or business of farming and a “qualified person” to discharge “qualified farm indebtedness” is eligible for a special procedure for reducing tax attributes and reducing the basis of property. A “qualified person” is someone who is “actively and regularly engaged in the business of lending money and who is not somehow related to or connected with the debtor.” “Qualified farm indebtedness” means indebtedness incurred directly in connection with the operation by the taxpayer of the trade or business of farming and 50 percent or more of the average annual gross receipts of the taxpayer for the three proceeding taxable years (in the aggregate) must be attributable to the trade or business of farming. Off farm income can create qualification problems, and a cash rent landlord is not a “farmer” that can qualify for the special rule.
But, if the requirements are met, a solvent farm debtor reduces tax attributes in a specific order, and an election can be made to reduce the basis of depreciable property first, before reducing the tax attributes. This may help to preserve the tax attributes for later use.
Relatedly, for solvent taxpayers who are not in bankruptcy, any negotiated reduction in the selling price of assets does not have to be reported as discharge of indebtedness income. To be eligible, the debt reduction must involve the original buyer and the original seller. Does the seller have adverse tax consequences from the forgiveness? The Internal Revenue Code says that any cancellation or forgiveness of payments must be treated as though received by the seller. But, the IRS has ruled in a private letter ruling that forgiveness of payments to help a financially troubled debtor does not result in income to the seller. So, there’s some uncertainty on that point.
The Center for Agricultural Law and Taxation does not provide legal advice. Any information provided on this website is not intended to be a substitute for legal services from a competent professional. The Center's work is supported by fee-based seminars and generous private gifts. Any opinions, findings, conclusions or recommendations expressed in the material contained on this website do not necessarily reflect the views of Iowa State University.