Taxing Lessons From Court Decisions

Decisions — All or nothing, or maybe something

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Image source: ID 8345807©Krutov Igor Dreamstime Stock Photos
Image source: ID 8345807©Krutov Igor Dreamstime Stock Photos

Between all or nothing is something.

The question in Bridges (Docket 228-15) is whether all, nothing, or something is the correct choice.

Prior to a divorce, the taxpayer purchased a vehicle and co-signed the loan with his now ex-wife.

In the divorce, the now ex-wife got the vehicle, and was ordered under the state court divorce decree to pay the associated loan. She did not do so, and after the divorce became final, the vehicle was repossessed and sold at auction. The auction price was less than the loan. The lender attempted to collect the difference, but was unable to, and after seven years, the lender declared the balance uncollectible and sent the taxpayer Form 1099-C, reflecting the cancellation of the indebtedness.

The taxpayer did not report the income from the cancellation of debt on his 2013 federal income tax return. He says the divorce decree is clear that the debt belongs to his ex-wife and is not income to him.

The IRS says he was a co-signer, and both he and his now ex-wife owed the debt. Therefore, the cancellation is income to him.

The tax court says the cancellation of debt is clearly income (internal revenue code section 61(a)(12)). The court also says congress did not expect the lender to determine whether the debtor had income from the discharge of the debt, so the fact that the taxpayer got Form 1099-C did not necessarily mean he had income.

Finally, the court says joint and several obligation on a debt, as here between co-signers, means the lender can legally sue either party or both of them, and that if one party pays the entire debt, that party can sue the other. Because of this right, the full amount of the discharged debt is not treated as income to each party. Instead the discharged debt is allocated between the parties.

The court then looked to state law, in this case Texas, which is a community property state, to determine the allocation. Under Texas property law, at the time of purchase the vehicle was community property, as was the debt, so the taxpayer and his now ex-wife each owned half of the vehicle and half of the debt at that time. Later, after the divorce was final, the ex-wife owned the vehicle and the debt. Which date controls the outcome, and what’s the correct answer to the amount of the taxpayer’s income — all, something, or nothing?

 

WHAT WOULD YOU DECIDE?

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THE DECISION

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Sorry, wrong answer :(
Right answer!

None of the cancelled debt was income to the taxpayer.

The vehicle, when the taxpayer and his now ex-wife purchased it together, was community property. The debt that they owed was a community debt. This was under state law, which is the law the court has to look at here.

What happened to that debt after the divorce? Well, for that again the court looked at state law, which in this case is the state court divorce decree, and it says quite clearly that the debt was the ex-wife’s and the vehicle was hers. If she had had the right to take interest deductions, they would have belonged to her. If somehow she had souped the vehicle up and it had become more valuable rather than less valuable and she had sold it, she would have been entitled to the profits; she would have had to pay the capital gains tax on it.

And so here the income that’s attributable to the vehicle, as a matter of state law, the court finds is entirely the former wife’s, and the taxpayer owes no deficiency. Oddly enough, representing himself, the taxpayer has won. Decision will be entered for the taxpayer.

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