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Whether or not there is cancellation of indebtedness income can sometimes be ambiguous and controversial. In Commissioner v. Rail Joint Co., a corporation issued its own bonds as a dividend to its shareholders. When the bonds declined in value, Rail Joint repurchased them for less than their face amount. Ordinarily, retiring bonds for less than the issue price would result in taxable canceled debt. However, in holding that there was no COD for Rail Joint, the court noted that, unlike in a normal issuance of corporate debt for cash consideration, the original issuance of these bonds as dividends did not increase the capital of the corporation and did not create burdened assets to be later freed by the cancellation.
The IRS has formally non-acquiesced to the Rail Joint doctrine, arguing that what really happens in these situations is a constructive dividend and purchase: The corporation constructively issues a cash dividend to shareholders, who then contribute that cash back to the corporation in exchange for the bonds; the burdened asset is thus the constructively re-contributed cash. Rail Joint is nonetheless good law, and has been expanded to encompass other situations where the taxpayer received nothing of value in exchange for the debt, such as when a guarantor of a loan who did not enjoy the benefit of the loan settles it for less than the face amount.
Whether secured debt is recourse or nonrecourse can have significant consequences if the debt is settled in foreclosure of the secured property. Generally, while the net gain or loss is the same regardless of the classification of the debt (it will always be the difference between the basis of the burdened property and the amount of the debt), there are potentially huge tax differences.
When property burdened by nonrecourse debt is foreclosed upon, there is no cancellation of indebtedness even if the amount of the loan exceeds the fair market value of the property. The case of Commissioner v. Tufts holds that in such a situation, the amount realized is the amount of the debt, and the fair market value of the property is irrelevant. That this difference between the adjusted basis of the property and the amount of the debt is simple gain rather than COD has potential upsides and downsides. On the one hand, the gain would be capital gain assuming the property foreclosed upon were a capital asset, unlike COD which is ordinary. On the other hand, COD is potentially excludable, as by insolvency (see below).
If the same property had been burdened by recourse debt, and, as above, that property were foreclosed upon in full satisfaction of the debt, you would get a different result. The gain or loss would be determined with reference to the fair market value of the property, and the difference between the fair market value and the debt would be COD. (This intuitively makes sense because with recourse debt, any cancellation of the outstanding balance of the debt, after it has been satisfied to the extent of the FMV of the property given up, really is a termination of personal liability to pay that amount, unlike in a situation where the debt is nonrecourse). If the property has a value lower than its basis, then in the case of recourse debt you could get a capital loss and COD ordinary income on the same transaction, netting to the same dollar figure as with nonrecourse debt but potentially much worse for the taxpayer: The taxpayer would not only be burdened with ordinary rather than potentially capital gains, but may have more total income to report, offset only by a capital loss that would be unusable (except to a nominal extent in the case of individuals) if the taxpayer had no other capital transactions for the year. Only in the case of a taxpayer able to utilize one of the COD exclusions, such as insolvency, could this result be better.
Disputed Debt Doctrine
The Disputed Debt Doctrine (also known as the Contested Liability Doctrine), is yet another exception to including COD income in gross income. This doctrine can be found in a Third Circuit Court of Appeals case, Zarin v. Commissioner. In order for this exception to apply, the amount of debt must actually be disputed. This can happen if the two parties actually have a good faith dispute over the amount owed. A written instrument containing the amount of debt will probably not satisfy this requirement. However, as the court decided in Zarin, the Disputed Debt Doctrine can also apply if the debt is not legally enforceable.