What Is a Tax Attribute?
Tax attribute refers to certain losses, tax credits, and the adjusted basis of property that must be reduced because of the exclusion of debt cancellation from a taxpayer's gross income. Tax attributes are adjusted when a taxpayer is insolvent or declares bankruptcy.
- Tax attributes are specific economic benefits, such as tax credits, that must be reduced by the amount of canceled debt excluded from income.
- There are seven types of tax attributes, including net operating losses, capital losses, and passive activity loss.
- The IRS does not require forgiven debt to be included as taxable gross income.
- Gains from discharged debt is not factored into taxable income.
- In exchange for favorable tax treatment, the insolvent or bankrupt taxpayer must forgo certain tax attribute benefits.
How Tax Attributes Work
According to the cancelation of debt (COD) income rules, canceled debt will not be taxable if:
- The debt was discharged in bankruptcy.
- The debtor is insolvent, with debts greater than assets, but only to the extent of the insolvency.
- The canceled debt was a gift or an inheritance from a friend or relative.
Individual and business taxpayers who are forgiven their debts due to insolvency or bankruptcy do not have to include the forgiven debt as part of their taxable gross income. However, the discharged debt translates to financial gain. Under ordinary taxation principles, the Internal Revenue Service (IRS) taxes most financial gains earned by individuals and businesses. In this case, Section 108 of the Internal Revenue Code (IRC) exempts gains from forgiven debt from being factored into taxable income, providing a measure of relief for certain taxpayers who find themselves facing serious financial difficulties.
However, the amount excluded from gross income is used to reduce certain tax attributes. Excluding income under Section 108 requires that a taxpayer postpone his or her tax liability by decreasing dollar-for-dollar (or in some cases, 1/3 of each dollar) certain tax attributes that would otherwise be available to offset future income. So, in effect, when a debt is canceled, the taxpayer forfeits some tax attribute benefits in exchange for receiving favorable treatment relating to the bankruptcy.
The Internal Revenue Code (IRC) stipulates that taxpayers must reduce seven tax attributes in the following order:
- Net operating loss from any business
- General business credit carryover
- Alternative minimum tax credit
- Capital loss
- The cost basis of property
- Passive activity loss
- Foreign tax credit carryover
Taxpayers may use IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness to reduce the basis of depreciable assets before reducing the other tax attributes.
Example of a Tax Attribute
For example, if $5,000 in debt was forgiven, then the taxpayer could elect to have the basis (cost price) of their rental property reduced by $5,000 and defer the tax until the property is sold. Reducing the cost basis of an asset means that a taxpayer will recognize a higher taxable gain (or smaller loss) from the sale of the asset. If the property is sold for a gain, then $5,000 of that gain will be taxed as ordinary income.