In general, if you are liable for a debt that is reduced, canceled, forgiven, or discharged, you must include the canceled amount in gross income unless you meet an exclusion or exception such as the taxpayer is in bankruptcy or insolvent. Other possible exceptions include: qualified farm debt, qualified real property business debt, a certain type of student loan, or qualified principal residence indebtedness. A special rule also applies to a reduction of a seller-financed (i.e., purchase money) debt owed to the seller of the property.
1. If your debt is secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have a reportable gain or loss. The gain or loss on such a deemed sale of your property is a separate issue from whether any cancelled debt also associated with that same property is includable in gross income.
2. If your debt is canceled by a private lender such as a relative or friend and the cancellation is intended as a gift, there is no income to you. While it’s not income to you, if the lender forgives more than $13,000 in a year (the gift tax annual exclusion), it may count against his or her own lifetime exemption from the gift tax. A debt canceled by a private lender’s will, upon his death, isn’t income to you either.
3. No amount is included in a debtor’s gross income by reason of a discharge of indebtedness in a bankruptcy case, even if the debtor is solvent after the discharge. If the indebtedness is discharged when the debtor is insolvent (but not in a bankruptcy case), the discharge is excluded from the debtor’s gross income up to the amount of the insolvency. The amount excluded under these “insolvency exceptions” must be applied to reduce the debtor’s tax attributes such as loss or credit carryovers or basis in assets.
4. A reduction of debt may also cause the recognition of income. A debtor may satisfy an outstanding “old” debt by issuing a “new” debt. The old debt is treated as having been satisfied with an amount of money equal to the issue price of the new debt. The excess (if any) of the “old” adjusted issue price over the “new” issue price is cancellation of debt income to the debtor.
5. Another exception that is available to taxpayers who are homeowners whose mortgage debt is partly or entirely forgiven during tax years 2007 through 2012 is for indebtedness discharged before January 1, 2013, gross income doesn’t include any discharge of qualified principal residence indebtedness. Qualified principal residence indebtedness is acquisition indebtedness under Code Section 163(h)(3)(B) with respect to the taxpayer’s principal residence, but with a $2 million limit ($1 million for married individuals filing separately).
It includes indebtedness incurred in the acquisition, construction, or substantial improvement of a principal residence that is secured by the residence. It also includes refinancing of debt to the extent the amount doesn’t exceed the amount of the refinanced indebtedness. “Principal residence” has the same meaning as under the home sale exclusion rules. The basis of the taxpayer’s principal residence is reduced by the excluded amount, but not below zero.
6. An exception to the usual treatment of debt discharge income may apply to contested liabilities. If a party demands payment for a liability over which there is a dispute, the eventual agreement to pay a reduced amount may not give rise to debt discharge income. In one court case, the taxpayer disputed the amount of interest and late fees added to his credit card balance. When he settled the debt for less than the balance on the credit card company’s books, only the amount of the liquidated debt (i.e., the amount fixed by agreement or by the operation of law) over the amount paid was taxable debt discharge income. The cancellation of the disputed charges did not generate debt discharge income.
7. In addition, farmers do not have to recognize debt discharge income if the forgiven debt is qualified farm indebtedness. For this exception, the following conditions must be met: (1) the debt was incurred directly in the business of farming; (2) at least 50% of the taxpayer’s gross receipts from all sources, including farming, for the preceding three years were attributable to the business of farming; and (3) the lender is unrelated to the taxpayer and is actively and regularly engaged in the business of lending money or is a government agency or instrumentality.
The amount of debt discharge income excludable by farmers is limited to the total of certain tax attributes plus the aggregate bases of business property and property held for the production of income. To the extent the debt discharge exceeds these attributes, income must be recognized.
8. A taxpayer who is not insolvent or bankrupt can elect to exclude from gross income any income from the discharge of qualified real property business debt.
Qualified real property business debt includes debt: (1) that was incurred or assumed in connection with real property used in a trade or business and that is secured by such real property; (2) that was incurred or assumed (a) before January 1, 1993, or (b) on or after January 1, 1993, and is qualified acquisition debt (i.e., debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business); and (3) with respect to which an election to invoke the special rules of IRC Sec 108(a) (1)(D) has been made.
9. Cancellations of all or part of certain student loans obtained to attend qualified educational institutions do not result in gross income to the borrower. This special rule applies only to student loans that contain a provision stating that all or part of the loan will be cancelled if the borrower works for a certain period of time in certain professions for any of a broad class of employers (i.e., a public service requirement), and the borrower satisfies such requirement. To qualify, the loan must be made by either: (1) a federal, state, or local government unit, or instrumentality, agency, or subdivision thereof; (2) a tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law; or (3) an educational institution that makes the loan under (a) an agreement with an entity described in item 1 or 2, or (b) a program of the institution to encourage students to serve in occupations or in areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or other tax-exempt organization.
10. If the taxpayer’s debt is reduced or eliminated they will normally receive a Form 1099-C, Cancellation of Debt. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.”
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at
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