NEW REQUIREMENTS CONCERNING THE DISCHARGE OF INDEBTEDNESS REPORTING
The PR Internal Revenue Code (“PR IRC”) provides a mechanism by which creditors may obtain a tax deduction in their income tax returns for the concept of forgiveness of debt. Nonetheless, debtors being discharged are required to recognize revenue for the same amount, unless an exclusion applies.
Given the recent increase in the number of instances where taxpayers claim an exclusion from having to recognize this type of income, perhaps triggered by Puerto Rico’s economic crisis, on November 7, 2016, the PR Treasury Department (“PRTD”) issued Administrative Determination No. 16-14 (“AD 16-14”), to clarify and expand on the administrative process to qualify for the debtors’ related exclusion of the income deemed earned by the debt discharge on two specific cases: (1) the income for the concept of discharge of debt from a mortgage loan, and (2) income for the concept of a debt discharge in case of insolvent taxpayers.
DISCHARGE OF INDEBTEDNESS
Section 1031.01(a)(6) of the PR IRC establishes that, generally, the income or benefit derived from the condonation or forgiveness of debt is considered taxable income to the debtor, unless an exclusion applies. The exclusion is applicable in the following cases:
- The discharge is the result of a bankruptcy petition granted by a court with authority to hear the case.
- The discharge occurs when the debtor is insolvent, in which case the amount excluded shall not exceed the amount of the debtor’s insolvency.
- For student loans that are discharged as a result of an employment benefit provided by certain professions and for certain employers, but the employer can’t also be the lender.
- The indebtedness discharged occurs as a result of the reorganization of a mortgage loan guaranteed by a qualified residence of the taxpayer in Puerto Rico when the original loan did not exceed $1 million.
CREDITOR’S INFORMATIVE RETURNS
AD 16-14 explains that every creditor that enters into an agreement to discharge debts greater than $500 is required to provide to the debtor an informative return to disclose the income resulting from the condonation of debt. Generally, the taxable income is disclosed through Form 480.6A Informative Return - Income Not Subject to Withholding. Nonetheless, when an exclusion is applicable to the debtor, the creditor will report the income through Form 480.6D Informative Return - Exempt Income and Exempt Income Subject to Alternate Basic Tax. In instances in which a debtor has both, taxable and exempt income, the creditor shall report each kind of income using the appropriate Informative Return.
EXCLUSION OF INCOME FOR THE CONCEPT OF THE DISCHARGE OF DEBT OF A MORTGAGE LOAN
The PR IRC establishes the benefits derived from the discharge of debt resulting from a reorganization of a mortgage loan secured by a qualified residence as income excluded from income tax. A residence is considered qualified if: (1) it is the principal residence of the taxpayer, and is located in PR, or (2) it is a secondary residence, that is located in PR, used by the taxpayer, or any member of the family, as a residence during the taxable year. The original amount of the debt can’t exceed $1 million, and the residence could not have been leased to a third party, or used for investment by the debtor, during the 2 years prior to the date of discharge. AD 16-14 considers the following transactions as mortgage loan reorganizations:
- Short sale: taxpayer finds a third party that buys the property secured by the loan. The difference between the sales price and the loan balance represents a debt discharge.
- Short pay-off: creditor usually discharges part of the debt and the taxpayer keeps the property.
- Discharge: transaction related to bankruptcy, in which the debt is secured.
- Payment by cession: debtor transfers the property to creditor, and creditor sells it, to satisfy the debt.
EXCLUSION OF INCOME FOR THE CONCEPT OF THE DISCHARGE OF DEBT DUE TO DEBTOR’S INSOLVENCY
I. Determination of the exempt amount
The PR IRC establishes that the amount of income from debt discharge excluded from taxation is limited to the amount by which the debtor was considered insolvent. A person or entity is considered insolvent when its liabilities exceed the fair market value of its assets, just prior to the condonation of the debt. Therefore, if the amount of debt is less than the insolvency amount, all the income from the debt discharge will be exempt. However, if the discharged amount exceeds the insolvency, only the amount that brings the debtor to the break-even point will be considered exempt; the remaining amount will be considered taxable income.
II. CPA Report to demonstrate insolvency
A debtor desiring to have the cancellation of debt income exempt from income tax pursuant to the insolvency exception must submit to the creditor an Agreed Upon Procedures Report (the “Report”), prepared by a CPA that belongs to a peer review program, demonstrating its insolvency. The Report must be submitted in the timeframe specified by the creditor, which shall not be sooner than 30 days after the debt discharge. For the transactions that took place during the calendar year 2016, debtors will have until January 31, 2017 to submit the Report to the creditor.
Once the creditor receives the Report, he/she shall make the insolvency determination, and shall proceed to inform the taxable or exempt income on the corresponding Informative Return.
We can assist you in assessing how the changes outlined herein may impact your business. Please contact your BDO Puerto Rico tax advisor for more information.