What is a tax attribute?
The tax attribute refers to certain losses, tax credits, and the adjusted basis of property that must be reduced due to the exclusion of debt forgiveness from a taxpayer’s gross income. Tax attributes are adjusted when a taxpayer is insolvent or declares bankruptcy.
Key points to remember
- Tax attributes are specific economic benefits, such as tax credits, which must be reduced by the amount of canceled debt excluded from income.
- There are seven types of tax attributes, including net operating losses, capital losses, and passive business losses.
- The IRS does not require canceled debt to be included in gross taxable income.
- Gains from discharged debt are not included in taxable income.
- In exchange for favorable tax treatment, the insolvent or bankrupt taxpayer must forgo certain tax benefits.
How tax attributes work
According to debt cancellation (COD) income rules, canceled debt will not be taxable if:
- The debt was paid in bankruptcy.
- The debtor is insolventwith debts greater than assets, but only to the extent of insolvency.
- The canceled debt was a gift or inheritance from a friend or relative.
Individual and corporate taxpayers whose debts are forgiven due to insolvency or bankruptcy are not required to include the forgiven debt as part of their gross taxable income. However, the discharged debt results in a financial gain. Under ordinary tax principles, the Internal Revenue Service (IRS) taxes most financial gains made by individuals and businesses. In this case, Article 108 of the Internal recipe code (IRC) exempts gains from debt forgiveness from taxable income, providing relief to certain taxpayers who find themselves in serious financial difficulty.
However, the amount excluded from gross income is used to reduce certain tax attributes. The income exclusion under section 108 requires a taxpayer to defer his tax liability decreasing dollar for dollar (or in some cases, 1/3 of every dollar) certain tax attributes that would otherwise be available to offset future income. Thus, in effect, when a debt is cancelled, the taxpayer renounces certain tax advantages in exchange for preferential treatment linked to the bankruptcy.
The Internal Revenue Code (IRC) states that taxpayers must reduce seven tax attributes in the following order:
Taxpayers can use IRS Form 982: Reduced tax attributes due to debt release to reduce the base of depreciable assets before reducing the other tax attributes.
Tax Attribute Example
For example, if a debt of $5,000 were forgiven, the taxpayer could choose to reduce the basis (cost price) of his rental property by $5,000 and defer the tax until the property is sold. Reducing the cost basis of an asset means that a taxpayer will recognize a higher taxable gain (or lower loss) from the sale of the asset. If the property is sold for a gain, then $5,000 of that gain will be taxed as ordinary income.
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