When Cancellation of Debt (COD) Income Can Be Tax-Free
Sometimes debts can pile up beyond a borrower’s ability to repay, especially if we are heading into a recession.
But lenders are sometimes willing to cancel (forgive) debts that are owed by financially challenged borrowers.
While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event.
General Rule: COD Income Is Taxable
When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs.
Fortunately, there are a number of exceptions to the general rule that COD income is taxable. You can find the exceptions in Section 108 of our beloved Internal Revenue Code, and they are generally mandatory rather than elective. The two common exceptions are:
- Bankruptcy
- Insolvency
The cost of being allowed to exclude COD income from taxation under the bankruptcy or insolvency exception is a reduction of the borrower’s so-called tax attributes.
You generally reduce these tax attributes (future tax benefits) by one dollar for each dollar of excluded COD income. But you reduce tax credits by one dollar for every three dollars of excluded COD income. You reduce these attributes only after calculating your taxable income for the year the debt cancellation occurs, and you reduce them in the following order:
- Net operating losses
- General business credits
- Minimum tax credits
- Capital loss carryovers
- Tax basis of property
- Passive activity losses and credits
- Foreign tax credits
As mentioned above, any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.
This taxpayer-friendly rule allows the borrower to take full advantage of any tax attributes available for the year of the debt cancellation before those attributes are reduced.
Principal Residence Mortgage Debt Exception
A temporary exception created years ago and then repeatedly extended by Congress applies to COD income from qualifying cancellations of home mortgage debts that occur through 2025.
Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income—or $375,000 if the borrower uses married-filing-separately status—from the cancellation of qualified principal residence indebtedness. That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.
Is Airbnb Rental Income Subject to Self-Employment Tax?
Do you owe self-employment tax on Airbnb rental income?
That’s a good question.
In Chief Counsel Advice (CCA) 202151005, the IRS opined on this issue.
But before we get to what the IRS said, understand that the CCA’s conclusions cannot be cited as precedent or authority by others, such as you or your tax professional.
Even so, we always consider what the CCA says as semi-useful information, so here’s some analysis that goes beyond what the IRS came up with.
The Exact Question
To be specific, the CCA asks whether net income from renting out living quarters is excluded from self-employment income under Section 1402(a)(1) when you’re not classified as a real estate dealer.
If excluded under IRC Section 1402(a)(1), you don’t owe self-employment tax on your net rental income. Needless to say, that’s the outcome you want to see, and I’m here to help.
The taxpayer addressed in this CCA was an individual who owned and rented out a furnished beachfront vacation property via an online rental marketplace (such as Airbnb or VRBO).
The taxpayer provided kitchen items, linens, daily maid service, Wi-Fi, access to the beach, recreational equipment, and prepaid vouchers for rideshare services between the rental property and a nearby business district.
The CCA’s Conclusions
According to the CCA, when you’re not a real estate dealer, net rental income from renting out living quarters is considered rental from real estate and is therefore excluded from self-employment income—as long as you don’t provide services to rental occupants.
The self-employment income exclusion for net rental income collected by a non-dealer is a statutory provision. The statute itself doesn’t say anything about providing services.
But IRS regulations state that providing services to renters can potentially cause you to lose the exclusion from self-employment income.
According to the CCA, you must include the net rental income in calculating your net self-employment income—which could cause you to owe the dreaded self-employment tax (ugh!)—if you provide services to renters and the services
- are not clearly required to maintain the living quarters in a condition for occupancy and
- are so substantial that compensation for the services constitutes a material portion of the rent.
So, according to the CCA, determining whether providing services to renters will trigger exposure to the self-employment tax is the big issue for folks who rent out living quarters.
The CCA’s anti-taxpayer conclusion rests on the giant assumption that the services provided by the taxpayer were above and beyond what was required. But were they? Probably not!
The Customarily Issue
According to IRS regulations, services are generally considered above and beyond the norm only if they exceed the services that are customarily provided to renters of living quarters.
Therefore, services that simply maintain a vacation rental property in a condition that is customary for rental occupancy should not be considered above and beyond and therefore should not trigger exposure to the self-employment tax.
In assessing whether services provided to renters are above and beyond what’s customary, circumstances obviously matter.
In the real world of vacation rentals in expensive resort areas, renters customarily expect and receive lots of services that might be considered above and beyond in other circumstances.
For instance, in resort areas, renters customarily expect and receive cable service; Wi-Fi access; periodic housekeeping services, including changing bedding and towels; repair of failed appliances; replacement of burned-out lightbulbs; replacement of dead smoke alarm batteries; access to recreational equipment such as bicycles, kayaks, beach chairs, umbrellas, and coolers; and so forth and so on. That’s a lot of services!
Why are lots of services provided in expensive resort areas? Because rental charges in expensive resort areas are—wait for it—expensive! The cost may be $2,000 or more per week or $5,000 or more per month, or even higher during peak periods—maybe much higher! So, rental amounts that could be attributed to the provision of all the aforementioned services would almost always be a small fraction of the overall rental charges.
In the context of expensive resort area vacation rentals, it’s hard to imagine what services would be so above and beyond the norm that the property owner’s net rental income would be exposed to the self-employment tax.
It shouldn’t matter if the services are provided directly by the owner of the property (unlikely) or indirectly by a rental management agency and included as part of the fee paid by the owner of the property (likely).
The Substantiality Issue
In assessing whether services provided to renters are above and beyond the norm, substantiality also matters.
A Tax Court decision addressed a situation where the taxpayer rented out trailer park spaces and furnished laundry services to tenants. The laundry services were clearly provided for the convenience of the tenants and not to maintain the trailer park spaces in a condition for rental occupancy. Tenants were not separately billed for the laundry services, and they were not separately paid for.
The Tax Court concluded that any portion of the rental payments that was attributable to the laundry services was not substantial enough to trigger exposure to the self-employment tax. Accordingly, the Tax Court opined that all of the trailer park owner’s net rental income was excluded from self-employment income.
As stated above, in the context of the rental of expensive vacation properties, any portion of rental charges that could be attributed to the provision of services would likely be insubstantial in relation to the overall rental charges. If so, according to the Tax Court, the provision of such services would not expose the property owner to the self-employment tax.
How to Section 1031 Exchange into a Delaware Statutory Trust
As you likely know, the Section 1031 tax-deferred like-kind exchange is one of the greatest wealth-building mechanisms for real estate investors.
With Section 1031, you can avoid taxes on all your property upgrades during your lifetime and then pass the property to your heirs when you die. The heirs receive the property with a step-up to fair market value, and they can likely sell the property and pay no taxes.
But what if you want to get off the landlord bandwagon? There are options. For example:
- You could use an UPREIT.
- You could invest in an opportunity zone fund.
- You could invest in a Delaware statutory trust as we explain here.
1031 Exchange Overview
The 1031 exchange, or like-kind exchange, has been around since the Revenue Act of 1921. Its purpose is simple: allowing you to swap a business asset without there being a taxable event, because your economic position hasn’t really changed.
The basics of a 1031 exchange are pretty straightforward:
- Before you sell the old asset, you must begin the exchange by contracting with a qualified intermediary.
- You may list up to three potential replacement assets within 45 days of the sale of your qualified asset.
- You must close on at least one of those three identified assets within 180 days of the sale.
- For the exchange to be fully tax-free, you must acquire a new asset of greater value than the one you’re selling. If you don’t trade up, you’ll likely have some taxable gain.
IRC Section 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment (relinquished real property) if the relinquished real property is exchanged solely for real property of a like kind that is to be held either for productive use in a trade or business or for investment (replacement real property).
Such Section 1031 assets include, among others:
- Residential or commercial real estate held for investment, rental, or business use
- Raw land held for investment
- Tenant-in-common-held real estate
- Delaware statutory trust interests
Assets that don’t qualify for Section 1031 include:
- Securities, stocks, and bonds
- Partnership interests
- Assets held as inventory
- Personal-use real estate
- Foreign real estate
What Is a Delaware Statutory Trust?
The Delaware statutory trust property ownership structure allows you (as a smaller investor) to own a fractional interest in large, institutional-quality, and professionally managed commercial property along with other investors. Note that with the Delaware statutory trust, you are an owner.
And it’s that ownership interest that makes an investment in a Delaware statutory trust a qualifying replacement asset for purposes of a 1031 exchange. Revenue Ruling 2004-86 confirms the Delaware statutory trust ownership and its qualification for a 1031 exchange.
Some Thoughts on Delaware Statutory Trust Investments
Liquidity. Delaware statutory trusts do not have a secondary market. This means your money is locked up in this investment, perhaps for up to 10 years.
Minimum investment. In general, most Delaware statutory trusts require that you be an accredited investor. Such trusts do their own due diligence on your status, but in general you meet the requirements for classification as an accredited investor when
- your income is $200,000 or more ($300,000 with your spouse) over the past two years, and you reasonably expect such income for the current year; or
- your net worth exceeds $1 million excluding the value of your primary residence.
Lack of control. Unlike with property you own yourself, you don’t have control over the property in the Delaware statutory trust. Of course, you also don’t have the day-to-day landlord headaches.
Leverage. You have heard the saying that you should use other people’s money to increase your rate of return. In the real estate investment world, this is common—and it can work. But if you had no mortgage on your 1031 property, you should consider investing in a non-leveraged Delaware statutory trust to reduce the risk that you could lose your investment.
Backup for the 45-day rule. When you have to identify up to three properties under the 45-day rule and then buy one of them within 180 days, you play with fire. Consider naming two properties and using the Delaware statutory trust as a backup. Should the other properties fail, you would use the Delaware statutory trust to preserve your tax-deferred status and live to play the Section 1031 card another day.
Park your investment. If you think the market for buying property will be better seven to 10 years down the road, you could do a Section 1031 exchange into a Delaware statutory trust as a way to park your investment.
Section 1031: Don’t Miss This Depreciation Election
As you likely remember, the Section 1031 exchange allows you to sell a piece of appreciated real estate and defer all the taxes if you invest the entire proceeds in like-kind property.
And then consider this: a cost segregation study allows you to separate qualifying real estate into separate components with shorter depreciable lives that speed up deductions and, in many cases, create immediate write-offs.
Can you (a) defer a large gain via Section 1031 and (b) immediately create a large write-off on the new asset with a cost segregation study?
You can, but you have to make sure you don’t miss this one important step.
1031 Exchange Overview
The Section 1031 exchange allows you to sell appreciated real estate and defer all taxable gains when you fully reinvest the sales proceeds into new qualifying real estate.
Key point. Many savvy investors continue using 1031 exchanges until death, when their relatives inherit the asset with a stepped-up basis. And then, because of that stepped-up basis, those relatives can likely sell that asset federal-income-tax-free.
Cost Segregation Overview
Residential real estate is depreciated over a life of 27.5 years, and commercial real estate is depreciated over a life of 39years.
An applied cost segregation study breaks that $800,000 building into components such as appliances, flooring, lighting systems, and land improvements. The components have lives of 20 years or less, qualifying them for faster depreciation and bonus depreciation as well.
For 2022, bonus depreciation is 100 percent, but it drops to 80 percent for 2023.
Key point. Cost segregation studies use the depreciation rules in effect when you place the property in service, not when you do the study. But you realize the tax benefits in the year of the study.
Calculating Basis in a 1031 Exchange
When you complete a 1031 exchange, the basis in your new asset is calculated by reducing its value by the deferred gain. That new basis amount can be accounted for in two different ways, described below.
Method 1: Track two assets. With this method, the remaining basis of the old asset continues on its original timeline and the new “additional” basis of the new asset starts on a new schedule.
Method 2: Track one asset. Here, you make the IRS regulation 1.168(i)-6(i)(2) election.
This election allows you to treat the sum of the exchanged basis and the new/excess basis as one asset, both put into service at the same time.
Cost Segregation Can Change the Game
If you will use cost segregation on the newly acquired Section 1031 asset, you may want to make the 1.168(i)-6(c)(5)(iv) election because that applies cost segregation to the entire basis.
Crowdfunding: Is It Taxable?
Crowdfunding is the process of asking members of the public for small amounts of money through any one of hundreds of crowdfunding websites.
Crowdfunding is used by both individuals and businesses, and the amount raised is substantial: over $17 billion is generated yearly through crowdfunding in North America.
Is this money taxable? Though it may seem strange given the amount of crowdfunding going on, there has yet to be a court decision or IRS ruling on the subject. The IRS has issued only two brief information letters. The gist of the information letters is that “the IRS will examine all facts and circumstances . . . and use general principles of income inclusion to determine the proper tax treatment.”
Under these general principles, gross income includes “all income from whatever source derived,” except where otherwise provided by law.
Thus, money obtained through crowdfunding is taxable income to the recipient unless there is a specific exception.
Not all crowdfunding is the same. There are four main types:
- Donation-based
- Rewards-based
- Equity-based
- Debt-based
Donation-Based Crowdfunding
Individuals use crowdfunding sites such as GoFundMe to solicit donations for themselves or other individuals. Donations can be solicited for any purpose, but typical campaigns involve raising money for medical expenses, youth sports, or education costs.
With donation-based crowdfunding, donors do not receive any goods or services in return for their money.
The average amount raised in such crowdfunding campaigns is $824, with an average donation of $96. There is no limit on donations, and people with truly compelling stories have raised extraordinary amounts—in some cases $1 million or more.
Like any other income, such crowdfunding donations are taxable income to the recipients unless there is an exception to the general rule. Fortunately, there is an exception: these donations are tax-free if they qualify as gifts.
Rewards-Based Crowdfunding
Rewards-based crowdfunding is an alternative form of small-business financing. Unlike donation-based crowdfunding, contributors or backers receive products or services from the business in return for their money. The best-known websites for rewards-based crowdfunding are Kickstarter and Indiegogo.
This form of crowdfunding is typically used by start-up businesses, but established businesses use it as well. It is often used for creative enterprises, including music, publishing, comics and illustration, film and video, design, and crafts. But all types of products and services are promoted through this type of crowdfunding.
The reward given to each contributor is generally based on the size of the contribution—the larger the contribution, the greater the reward. For example, a Kickstarter project that developed a playhouse for cats gave small contributors a picture of cats with the contributor’s name inscribed on it, while larger contributors were given a set of blocks to build the playhouse.
Equity-Based Crowdfunding
With equity-based crowdfunding, no goods or services are given to investors. Instead, they get shares in the company or, in some cases, convertible notes that can be turned into shares later. Websites for equity crowdfunding include. Republic, CircleUp, and Fundable.
Equity crowdfunding enables a business to raise a substantial amount of money without taking on new debt. But to prevent fraud and other abuses, companies that use equity crowdfunding must comply with federal and state securities laws.
The U.S. Securities and Exchange Commission (SEC) allows private companies to legally raise up to $5 million in a 12-month period through equity crowdfunding. But the business must comply with financial and other disclosure requirements and make filings with the SEC.
A business, typically a corporation, does not have to pay business taxes on funds raised by issuing securities to investors. Such funds are not considered business income.
Debt-Based Crowdfunding
Debt-based crowdfunding, also called peer-to-peer (P2P) lending, is an alternative to traditional loans. Instead of borrowing money from a bank, a business or individual obtains a loan from a lending website. These are formal loans with a specified principal amount, interest rate, term, and monthly payment schedule.
For each loan it approves, the crowdfunding lender issues a series of notes that it offers to investors through its website. Payment on the notes is contingent on payment of the underlying loan by the borrower. The lending website charges the borrower a loan origination fee and charges the investors a service fee.
Loans that must be paid back are not taxable income to the borrower. If a crowdfunding loan is business-related, the interest is a deductible business expense. The borrower should also be able to deduct the loan origination fee as original issue discount (OID) interest expense over the life of the loan.
Is Mileage to Rental Properties Tax-Deductible?
Question
I received an email from my tax advisor that said I could deduct car mileage to and from my rental property.
I don’t think this is right. I think the trip from my home to and from my rental property is a non-deductible personal commute. But I would love to be wrong. Am I wrong?
Answer
No—unfortunately, you are right. Your mileage between home and the rental property is commuting mileage. It’s not deductible.
We’ll get to that in a moment, but first we have to say that the email you received did contain the right tips telling you to track your mileage; dates; odometer readings; and reasons for the mileage, such as making repairs, checking out prospective tenants, and collecting rents.
Now, let’s go back to your mileage. The trips from home to and from your rental properties are non-deductible personal commutes.
But if your rental properties rise to the level of a business, then you could install an office in your home (a home office), and that would make the trips from your home to and from your properties deductible. See the article.
Are Your Rental Properties a Business? If So, You Win
for when rental properties can qualify as a business and why that’s good for your taxes.
Q&A: Home-Office Deduction for Orthodontist
Question
My client purchased a subscription to your service. Because of him, you have me as a member too.
Bob, my client, wants to claim a home-office deduction. He is an orthodontist. His employees and contractors do the billing and accounting for his practice.
Bob and his wife (who is an employee) do payroll once a month in the home office.
Bob’s primary use of the home office is preparing treatment plans for his patients. My concern is whether the preparation of treatment plans is an administrative or a management activity. Can you give us your opinion?
Answer
Sure. In fact, we’ll do that and a little more. Here are the answers to your question and some rules of the road for your client’s home-office deduction:
- Look at your client only. His staff does not impact his ability to claim a home-office deduction. In other words, the law doesn’t care what his staff does.
- To get this home office right, your client should consider doing all his administration at home. He should make his practice office his patient office—nothing more, period.
- Preparing treatment plans meets the rules for administrative use of the home office.
- To know for certain that administrative use qualifies
- Your client needs to meet the regular use requirement.
Q&A: Two More Reasons NOT to Rent Equipment to Your Corporation
Question
We are CPA subscribers, and we love your newsletter.
We have two questions about renting equipment to your corporation, as you discussed in
Rent Equipment to Your Corporation; Qualify for Section 179 Expensing.
- Does the taxpayer incur self-employment taxes on this rental of personal property?
- Do I need to consider potential sales tax that the state might charge?
Answer
First, thanks for being subscribers, and thanks for the comment.
Also, thanks for two excellent questions.
The rental of equipment, as we described in Rent Equipment to Your Corporation; Qualify for Section 179 Expensing, could rise to a level where it could trigger the self-employment tax, according to IRS Chief Counsel Advice (CCA 1996-13).
The tax code exempts from self-employment taxes both (a) the rental of real estate and (b) the rental of real estate that includes personal property, such as when you rent a furnished apartment. There is no such exemption for the rental of personal property only.
We should note that the chief counsel requested some specific equipment cases from the field to which he could apply the contents of the advice. We found nothing beyond this 1996 advice that indicates anything from the field.
But when we consider the hazard of incurring the self-employment tax on top of the difficulty of obtaining the Section 179deductions, the rent to your corporation strategy becomes even less appealing than we deemed in the original article. The self-employment tax possibility adds to the negative issues of renting to the corporation and makes the positives of a corporate purchase of the equipment or an accountable plan reimbursement to the owner-employee a lot more appealing.
Now to your second question: yes, the rental can generate a state sales tax depending on state law, and if it does, that sales tax adds another hefty negative to the strategy of renting equipment to your corporation.