Well, while I was on my weekly cross-country ski trip this morning, I was thinking about the several tax returns I've done in the past couple of years with cancelation of debt income excluded because of insolvency. While none of these had the situation I now describe, I can easily envision it happening.
Suppose a taxpayer has a Roth IRA with, say, a balance of $11,000 at the end of 2009, and excluded cancelation of debt income sufficient that all tax attributes have to be reduced to zero. The question I pose is: does the basis of the Roth IRA need to be reduced along with other tax attributes? And if so, when do distributions from the Roth IRA become taxable because of the reduction in basis. I think that it's likely the basis is reduced.
Let's suppose that a couple of years from now the Roth IRA balance is $22,000, and the taxpayer takes a distribution of half of it. I can see three possible tax scenarios: (1) The distribution is fully taxable because the reduction of basis is treated like depreciation, and recaptured first, as would be the case in an installment sale. (2) The distribution is 50% taxable, because it is apportioned between the zero-basis amount and the full-basis amount in the Roth IRA, similar to the allocation of distributions from a traditional IRA with non-deductible contributions. (3) The distribution is not taxable, because the zero-basis portion is the last portion of the Roth IRA to be distributed, similar to the way distributions in excess of basis are treated in partnerships and S corporations.
My initial conclusion is that the zero-basis portion is recovered first, resulting in the earliest taxation of the IRA. What do you think?