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Better Tax Options for Unpayable Debts

This is worst-case planning that hopefully you’ll never need. But if the downturn in commodity prices has trapped you with unpayable debts, consider contacting an attorney and accountant or tax preparer with experience in workouts and their tax consequences. Tax laws are more favorable for you now than during the debt crisis of the 1980s, when debt write-offs were considered income by the IRS. After changes in tax laws in 1986, you can now escape some of that tax burden, but tax issues remain a tricky minefield.

Most farmers with troublesome debts aren’t at the write-off stage yet, says Charles Brown, an Iowa State University Extension farm management specialist for the southeast part of the state. 

“You’ve got to have low net worth or no net worth before lenders forgive any debt,” says Brown, who has many years of experience helping farmers prepare taxes.

If you get to that point, you now have better tax options. 

“Let’s say you have a loss of $100,000 carried forward. If you have a $100,000 bank write-off, you can offset it with the net operating loss,” Brown says. 

If you take an even more drastic approach to reorganizing debt through Chapter 11 bankruptcy, then if you sold assets to reduce debt in the year before filing for bankruptcy protection, you may not have to pay taxes on that income, Brown says. 

Brown knows two farmers who came back from the brink of business failure in the 1980s by using bankruptcy. They are still farming today. Still, if you end up taking bankruptcy, it’s a loss for you and the lender.

In Brown’s region, he hasn’t seen many bankruptcies in the current downturn. “What I do see is a lot of restructuring. There should not be any tax consequences of restructuring,” he says.

That may be true for loans whose terms are extended. There are, however, tax consequences for four different approaches to dealing with debt, says Neil Harl, an emeritus professor of economics at Iowa State University who remains a national authority on agricultural law and taxation.

  • Voluntarily deeding land or equipment to a lender. If this does not cover the debt, “what you really have is the gain or loss on the land, and any further discharge of debt beyond that may be taxable. However, you may be able to reduce the basis for other assets,” says Harl.
  • Debtor in bankruptcy. If you are in Chapter 11 bankruptcy, you have no capital gains, but the tax basis of the estate’s property is reduced. This could result in higher capital gains taxes years later.
  • Discharge of debt when not in bankruptcy, but the farm is insolvent immediately before the write-off. That debt forgiveness is not considered taxable income. 
  • Discharge of debt for a farm that is still solvent. Before federal tax reforms in 1986, this would have been taxable income. Now it is not, although you reduce tax attributes such as capital loss carry-overs and the tax basis of property. Not all borrowers or lenders qualify, however. More than half of the borrower’s gross receipts have to come from farming in the three previous tax years. So, small farms with more off-farm income might not be able to use this. Also, the debt must be held by a commercial or government lender, not someone selling land on a contract for deed, for example, or a relative. 

“People have gotten into trouble because Grandma loaned them the money, and they thought this applied to them. It doesn’t,” Harl says.

This is just a glance at complex tax issues that require competent legal and accounting advice. For example, you could still owe alternative minimum tax on write-offs, which the IRS calls discharge of indebtedness income.

“The key thing is, if you’re in financial stress, don’t put off talking to your lender,” Brown says.

Learn more

Tax Considerations in Liquidations and Reorganizations University of Minnesota Extension 

Tax Consequences When Debt is Discharged  Center for Agricultural Law and Taxation Iowa State University

Publications 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for individuals)  Internal Revenue Service

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