Cancelled Debt Isn't Excludible from Income as Qualified Principal Residence Debt

(Parker Tax Publishing July 2020)

The Tax Court held that income from the cancellation of two loans made to a taxpayer by her employer, in order to help her and her husband pay for a new home, was not excludible from income as qualified principal residence indebtedness. The court noted that while the couple used most of the loan proceeds to purchase the home, the promissory note detailing the terms of the loan did not provide that the indebtedness was secured by the property and was not recorded with the Los Angeles County, California, Registrar-Recorder. Weiderman v. Comm'r, T.C. Memo. 2020-109.

In 2006, Jennifer Weiderman accepted an offer of employment from K-Swiss, a California shoe and apparel company. She was hired as VP - Marketing at a salary of $25,000 monthly. Mrs. Weiderman and her husband moved to Southern California where K-Swiss was located, and K-Swiss granted her an interest-free loan of $500,000 to help finance the purchase of a home in the area where the company was located. That loan was memorialized by a promissory note dated February 15, 2007. The employment agreement stated that K-Swiss would pay Mrs. Weiderman six months of salary, i.e., $150,000, as severance compensation if she was terminated without cause before January 1, 2009. The couple purchased a home in Agoura Hills, California for $1,950,000.

On December 1, 2008, K-Swiss terminated Mrs. Weiderman's employment. K-Swiss demanded that Mrs. Weiderman and her husband repay the $500,000 loan. Knowing that the only way they could pay back the loan was to sell the Agoura Hills property, the couple listed (with the assistance of a real estate agent) the Agoura Hills property for sale and hired an employment attorney to negotiate a settlement with K-Swiss. Initially, K-Swiss offered to cancel $250,000 of the $500,000 loan in lieu of a cash severance payment. Ultimately, the Weidermans agreed to having K-Swiss cancel $220,000 of the loan and pay them $30,000.

As part of Mrs. Weiderman's separation agreement with K-Swiss, the Weidermans were obligated to sign (1) a new promissory note, dated January 29, 2009, for $280,000 in favor of K-Swiss, replacing the February 15, 2007, promissory note and (2) a deed of trust also in favor of K-Swiss and recordable against the Agoura Hills property to secure payment of the $280,000. The January 29, 2009, promissory note reiterated K-Swiss' agreement to cancel the February 15, 2007, promissory note. It also set forth the conditions for repayment of the $280,000 - that the amount would be due and payable in full upon the sale of the Agoura Hills property or, if the net proceeds from that sale were insufficient to pay this amount, the amount would be due on January 31, 2010.

On May 20, 2009, the Agoura Hills property sold for $1,665,000. Shortly before the sale Mrs. Weiderman and K-Swiss agreed to amend the 2009 separation agreement to reflect an additional forgiveness of outstanding debt - this time, $35,000 of the $280,000 loan, leaving a balance of $245,000. Under a new agreement, the Weidermans agreed to repay the $245,000 as follows: (1) $200,000 to be paid upon the sale of the Agoura Hills property, and (2) the balance to be paid in two equal installments on January 31, 2010 and 2011, respectively. The Weidermans missed the first payment and renegotiated the loan again. In June of 2010, in exchange for a payment to K-Swiss of $15,000, K-Swiss forgave the remaining $30,000.

When the Weidermans filed their 2009 tax return, they did not report the cancellation of debt (COD) income totaling $255,000 as ordinary income or their receipt of the $30,000 despite K-Swiss sending the IRS and Mrs. Weiderman a Form 1099-MISC for 2009 reflecting the $255,000 as non-employee compensation. Instead, the Weidermans reported the $255,000 on Mrs. Weiderman's 2009 Schedule C as gross receipts attributable to JW Consulting, an unincorporated business that Mrs. Weiderman claimed provided marketing and brand consulting. That income was offset by reported business expenses totaling $73,116.

After consulting with a CPA, Mr. Burkholder, the couple filed an amended return on which they removed the $255,000 of gross receipts from Mrs. Weiderman's 2009 Schedule C and reported this amount as nontaxable COD income, resulting in an overpayment of approximately $88,000. In explaining the change, the Weidermans stated that income from qualified principal residence debt forgiveness in the amount of $255,000 was incorrectly reported on the original return as ordinary business income. The $255,000 of mortgage debt forgiveness, they said, was incorrectly reported on Form 1099-MISC when the amount should have been reported on Form 1099-C. The couple reported the $255,000 of qualified principal residence mortgage debt forgiveness on the amended return on Form 982 as a reduction of the basis of the principal residence.

Under Code Sec. 108(a)(1)(E), gross income does not include amounts which would be includible as COD income if the indebtedness discharged is qualified principal residence indebtedness. The term "qualified principal residence indebtedness" is defined as acquisition indebtedness with respect to the taxpayer's principal residence. Code Sec. 163(h)(3)(B)(i) provides that acquisition indebtedness is any indebtedness which is (1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer and (2) secured by that residence. For these purposes, secured debt is any debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract) that makes the debtor's interest in the qualified residence specific security for the payment of the debt (1) under which, in the event of default, the residence could be subjected to the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated and (2) is recorded or otherwise perfected in accordance with the applicable state law.

The couple's 2009 tax return was selected for audit. The IRS determined, among other adjustments, that (1) the $30,000 received from K-Swiss in accordance the 2009 separation agreement was additional taxable "other" income to them, and (2) the amount of the couple's debt that K-Swiss forgave - $255,000 for 2009 and $30,000 for 2010 - was taxable "other"/COD income to them. Finally, the IRS determined that accuracy-related penalties for substantial understatements of income tax, or in the alternative, for negligence should be imposed. The couple challenged the IRS's assessments in the Tax Court.

Analysis

The Tax Court agreed with the IRS and held that the COD income was taxable to the Weidermans and was not excludible from income as qualified principal residence indebtedness. The court noted that while the Weidermans used most of the $500,000 loan proceeds to purchase the Agoura Hills property, the promissory note for the $500,000 did not provide that the indebtedness was secured by the Agoura Hills property. Additionally, the promissory note was not recorded with the Los Angeles County, California, Registrar-Recorder. The $500,000 loan was therefore unsecured debt, the court said, and since it was unsecured debt, it was not acquisition indebtedness within the meaning Code Sec. 163(h)(3)(B)(i). Thus, the court concluded, K-Swiss' cancellation of $220,000 of that indebtedness was not cancellation of qualified principal residence indebtedness within the meaning of Code Sec. 108.

The court then looked at the January 29, 2009, promissory note which created an indebtedness of $280,000 in favor of K-Swiss, together with a deed of trust also in favor of K-Swiss and recordable against the Agoura Hills property to secure payment of that new indebtedness. Although K-Swiss recorded the deed of trust with the Los Angeles County, California, Registrar-Recorder, the $280,000 debt was not "incurred in acquiring, constructing, or substantially improving" the Agoura Hills property. Indeed, the court noted, the January 29, 2009, promissory note conditioned repayment of the $280,000 upon the sale of the Agoura Hills property. Like the indebtedness of $500,000, the indebtedness of $280,000 was therefore not acquisition indebtedness, and thus K-Swiss' cancellation of $35,000 of that indebtedness shortly before the sale of the Agoura Hills property was not cancellation of qualified principal residence indebtedness.

With respect to the amended promissory note for $245,000 that the Weidermans executed in favor of K-Swiss, the court found that it also did not provide that the indebtedness was secured by the Agoura Hills property. Thus, like the $280,000 debt, the $245,000 debt was not "incurred in acquiring, constructing, or substantially improving" the Agoura Hills property and was not acquisition indebtedness. As a result, K-Swiss' cancellation of $30,000 of that debt in the June 2010 settlement agreement was not cancellation of qualified principal residence indebtedness.

Finally, the court held that the Weidermans were liable for penalties assessed by the IRS because, the court said, they failed to prove that they had reasonable cause for their underpayments within the meaning of Code Sec. 6664(c). The court noted that Mr. Burkholder testified at the trial that the Weidermans disclosed limited information to him concerning their 2009 Schedules C and the COD income for 2009 and that he gave them a range of options with respect to amending their 2009 return, leaving the decision to them as to what income and expense items for 2009 should be corrected.

For a discussion of the tax treatment of discharged debt that is qualified principal residence debt, see Parker Tax ¶76,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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