Discharge of indebtedness Income

What is the name of your state? Minnesota

Facts: Taxpayer and spouse originally filed separate income tax returns for year 2000.

Taxpayer (husband) loaned $150,000 to the spouse's unincorporated business - a hair salon. The spouse reported her business activity on Schedule C, Form 1040 (sole proprietor).

The spouse's hair salon business failed and she eventually went out of business. On his separately filed return, the taxpayer wrote-off the $150,000 loan as a non-business bad debt, long-term capital loss on Schedule D.

At the time of the bad debt write-off, the spouse was insolvent (her liabilities exceeded her assets). The taxpayer was not insolvent.

The general rule is that discharge of indebtedness results in income to the borrower.

The spouse did not include discharge of indebtedness income in her originally filed separate return.

Code Section 108 provides an acception to the general rule: a discharge of indebtedness will not be included in income where it involves the discharge of an insolvent taxpayer.

The taxpayer and spouse subsequently filed an amended return to change filing status from married filing separate to married filing joint return. As part of the amended return, the taxpayers removed the $150,000 capital loss deduction from Schedule D.

Issues:

When a married couple files a married filing joint return, are they considered a single taxpayer or taxpayers?

Based on the facts presented, is the taxpayer allowed a non-business bad debt deduction on Schedule D and is the discharge of indebtedness income not taxable to the spouse (individually, she was insolvent at time of bad debt)?

Code Section 108 speaks of a "taxpayer," but it does not define "taxpayer." Is a married couple filing a joint return considered 2 taxpayers?

I appreciate any comments you might provide. Thank you.

[abezon]

An MFJ couple is 1 taxpayer. They cannot write off the "bad debt". However, there is probably a net operating loss from the business failure, which could be carried back/forward to reduce taxes in other years. An NOL is actually better than a capital loss, since you can claim as much as necessary to reduce your tax to $0, rather than $5,000/year.

I doubt the husband was allowed to claim the bad debt in the first place. The IRCode has a number of prohibited transactions, and claiming capital losses for bad debts to your spouse is likely one of them.