8133 / What is the discharge in bankruptcy exclusion and in what manner must the taxpayer reduce certain tax attributes?

Clearly, because all debt discharged in any type of bankruptcy proceeding (i.e., Chapter 7, Chapter 11, Chapter 13) is excluded from gross income, it is the most generous of all the exclusions.

Example: On January 2, 2027, listing debt of $1,000,000, Asher's files a Chapter 7 bankruptcy petition. In September of 2027, the bankruptcy court discharges the entire $1,000,000. Because the discharge occurred in bankruptcy, all of it is excluded from gross income.

The discharge in bankruptcy exclusion, however, comes with a potential cost. If the taxpayer has certain tax attributes (listed in IRC Section 108(b)(2)), the taxpayer must reduce those attributes in the listed order (with the option to change the order of reduction by election) up to the amount of the discharge of debt income excluded from gross income. The sequence of the reduction of the tax attributes is as follows:

• NOLs
• General Business Credit
• Minimum Tax Credit
• Capital Loss Carryovers
• Basis Reduction (Depreciable and Non-Depreciable Property)
• Passive Activity Loss and Credit Carryovers
• Foreign Tax Credit Carryovers
  

In the alternative, the taxpayer may elect to reduce basis in depreciable property as the first attribute reduced. In that case, the order of reduction of tax attributes would be as follows:

• Basis of Depreciable Property
• NOLs
• General Business Credit
• Minimum Tax Credit
• Capital Loss Carryovers
• Basis Reduction (Non-Depreciable Property)
• Passive Activity Loss and Credit Carryovers
• Foreign Tax Credit Carryovers

As noted above, the exclusion of the discharge of debt income is unconditional. So, if a taxpayer lacks some or all of the above listed tax attributes or they are not sufficient to offset the entire amount of discharge of debt income, the exclusion remains intact. Therefore, it is possible that a taxpayer with few or no tax attributes may exclude a substantial amount of discharge of debt from gross income with minimal or no collateral tax consequences.
Example: In January, listing debt of $1,000,000, Asher's files a Chapter 7 bankruptcy petition. In September, the bankruptcy court discharges the entire $1,000,000 of debt. Because the discharge occurred in bankruptcy, it is all excluded from gross income. Asher's only listed tax attribute is a $50,000 NOL. So beyond reducing the NOL to zero, there are no further tax consequences to Asher. Bottom line: Asher excludes $1,000,000 of discharge of debt income and reduces his $50,000 NOL to zero. On the other hand, if Asher possessed any of the other listed tax attributes, they would have been reduced, accordingly.