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As the retail and office rental markets continue to soften, the use of the insolvency exception to avoid ordinary income on cancellation of indebtedness is magnified. Generally, discharge of indebtedness is taxable income to the borrower. The taxable amount is the difference between what is owed on the debt and the amount paid to settle the obligation.

However, if the borrower is insolvent before and after the discharge, taxable income is not recognized. “Insolvency” is the excess of liabilities over the fair market value of assets, yet nothing in the Internal Revenue Code or its regulations defines the term “liabilities.” To count as a liability in the insolvency calculation, the obligation must burden assets.

In Catrina E. White v. Commissioner, T.C. Memo. 2023-77 (June 21, 2023), Tax Court Judge Paris looks at when unpaid rent is treated as a liability for purposes of determining insolvency. The courts have previously determined that a liability must be enforceable to be included, however, this case looked at the question of what happens if the lender takes no action to actually collect or enforce the debt.

In 2016, Ms. White received a Form-1099 reporting cancellation of indebtedness income of $14,343.00. This arose from a bodysugaring business which had entered into a three-year lease.

The lease provided that she failed to pay rent on time for two months in a row, the full amount of the remaining lease would be due in full and had to be repaid within the third month. On Jan. 15, 2016, she received a letter from the lessor stating that she had breached the lease and owed the full amount of the remaining rent of $21,700.00. She stopped making her payments in 2016 and the business closed later that year. In November 2016, the lender gave up and wrote off the loan, sending her the Form 1099-C reporting cancellation of indebtedness. However, the lessor did not make any indication it had forgiven the unpaid rent. However, it made no efforts to collect the unpaid rent. It is unclear whether the lessor was able to relet the property. At the time of the debt discharge Ms. White claimed that she was insolvent, including the unpaid rent as one of her liabilities.

The IRS responded that the unpaid rent should not be treated as a liability because neither party treated the claimed obligation as a real obligation because the lessor did not sue or take any action to collect the rent, nor did Ms. White make any payments. The IRS claimed it was just a paper obligation, not a real one.

Judge Paris, citing a Ninth Circuit case in Merkel v. Commissioner, stated that the issue did not turn on whether the debt was actually enforced, but rather, whether the obligation was legally enforceable at the time of the discharge. Ms. White was able to prove that it was both legally enforceable by the terms of the lease agreement and the Jan. 16 letter where the lessor asserted its rights to the $21,700.00. Even though the debt was not being actively pursued by the lender, it was still treated as a true obligation for income tax purposes.

The White case has wide ranging implications, since in the aftermath of the COVID pandemic, millions of square feet of office and retail space remains vacant — some of which is subject to a lease. To the extent a tenant is able to negotiate a reduction or nonpayment of rent, this could result in cancellation of indebtedness income. If insolvency can be established before and after the discharge of rent, the tenant may be able to avoid adverse tax consequences associated with the discharge, including the recognition of cancellation of indebtedness income.

Phil Jelsma is a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson (CGS3) — a Southern California-based commercial real estate law firm. The article was published in The Daily Journal and The Daily Transcript (subscription required).