An IRS tax attribute refers to a reduction that a taxpayer must make in a tax credit, tax loss, or when a lender cancels a debt the taxpayer owes. There are seven types of tax attributes. These include net operating losses and business credit carryover, capital losses, passive activity loss, minimum tax credits, credit carryover, property bases, and foreign tax credits.
How Tax Attributes Work
The cancellation of debt (COD) income rules states that canceled debt is not taxable if it:
- In bankruptcy, the debt was discharged.
- The debtor is declared insolvent if they have more debts than assets. However, only the extent of insolvency will be considered.
- The gift or inheritance of a friend or relative canceled the debt was the reason.
Individuals and businesses who have forgiven their debts through insolvency or bankruptcy don't need to include it as part of their taxable income. The discharged debt is a financial gain. According to normal taxation principles, the Internal Revenue Service (IRS) taxes the majority of financial gains made by individuals or businesses. Section 108 (IRC) of the Internal Revenue Code exempts gains from forgiven loans from being included in taxable income. This provides some relief for taxpayers who are facing financial hardship.
The amount excluded from gross income can be used to reduce some tax attributes. Section 108 allows taxpayers to postpone their tax liability by decreasing dollar for dollar (or in some cases 1/3 of each dollar) some tax attributes to offset future income. In effect, a taxpayer loses certain tax attributes benefits when a debt is canceled in exchange for favorable treatment related to bankruptcy. According to the Internal Revenue Code (IRC), taxpayers are required to reduce seven tax attributes.
- Any business can experience a net operating loss
- Carryover of general business credit
- Alternative tax credit
- Capital loss
- The property's cost base
- Loss of passive activity
- Foreign tax credit carryover
Example
If $5,000 of debt is forgiven, the taxpayer can elect to have their rental property's cost basis (or cost price) decreased by $5,000 and defer tax until the property sells. A taxpayer who reduces the cost basis of an asset will be able to recognize a greater taxable gain or a smaller loss from the sale. $5,000 of the gain will be subject to ordinary income tax if the property is sold as a gain.
Context
A person who receives bankruptcy protection has her debts discharged. This is a financial gain. This gain should be counted towards taxable income in principle. These gains are not included in taxable income under Section 108 of the Internal Revenue Code. This special measure indicates that the person is experiencing financial difficulties.
Rationale
Section 108 was created to assist the individual taxpayer and to limit the taxpayers' burden. The rules stipulate that anyone with a discharged loan must reduce tax attributes to the extent that it equals the discharged amount.
Attributes
These seven tax attributes are listed in a particular order. These include net operating loss of any business, business credit carryovers, minimum tax credit; capital loss; the basis of property; passive and credit loss; and foreign taxes credits. The basis of the property refers to the amount a person uses to pay for an asset. A person who reduces his basis will pay more capital gains tax when he sells an asset.
Application
To reduce tax attributes, the taxpayer must use IRS Form 922. This will allow them to take the maximum reduction possible for each one before moving on to the next. Continue this process until all discharged debt amounts have been accounted for or all attributes are reduced to the maximum extent possible. It is common to match dollar-for-dollar the reduction and discharged debt. Each 33.3 cents reduction in credit carrying overs is considered to be equaling $1 of discharged debt.
What Is The Importance Of A Tax Attribute?
Discharged debts are generally not taxable income. The IRS requires that discharged debts be reduced in taxpayer's tax attributes to ensure that borrowers don't receive a significant benefit from debt discharges. Bankruptcy is usually when tax attributes are revealed.
Making the Reduction
After calculating the tax for the year of debt cancellation, make the necessary tax attribute reductions. Reduce net operating losses and capital loss by first reducing the loss for the year of debt cancellation and then any loss carryovers to the year in that order, beginning with the earliest tax year. Reduce credit carryovers by the order that carryovers were considered for the tax year in which the debt cancellation occurred.
