Canceled debt is it taxable or not?

Over the past few years, banks have cancelled billions of dollars of debts. As a result, taxpayers may have unexpected tax consequences when debt is cancelled. This is commonly known as Cancellation of Debt Income. A debt includes any indebtedness whether you are personally liable, or liable only to the extent of the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, repossession, a voluntary return of the property to the lender, abandonment of the property, or even a loan modification.

In general, if you are liable for a debt that is canceled, forgiven, or discharged, you will receive a Form 1099-C, Cancellation of Debt, and must include the amount canceled in gross income unless you meet an exclusion. You must report the taxable amount of a taxable canceled debt as ordinary income, whether or not you receive a Form 1099-C.

However, a taxpayer's indebtedness must result from either debt for which the taxpayer is liable; or debt subject to which the taxpayer holds property as security for the loan. For example, if the lender cannot legally enforce the debt, then the taxpayer is not liable for that debt and will therefore not have tax consequences. If you received a Form 1099-C and the information is incorrect, contact the lender to have them make corrections. Remember, if loan forgiveness is the result of a gift or inheritance, it is not treated as cancellation of debt income.

You should be aware that if your debt was secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you are treated as having sold that property and may have a taxable gain or loss. The gain or loss on such a "deemed" sale of your property is an issue separate from whether any cancellation of debt income associated with that same property is includable in gross income.

But all is not lost, as there are many exceptions to the general rule. The reasons for these exclusions vary. For example, even the IRS realizes it is difficult to collect tax from insolvent or bankrupt taxpayers. The farm indebtedness provision, on the other hand, represents a political decision to subsidize farmers by offering a tax benefit, and the student loan exclusion for those who do certain types of work is designed to encourage a desired behavior and to maximize its benefits.

Canceled debts that meet any of the following exclusions are not taxable:

Discharge of indebtedness in a title 11 case

A Chapter 11 case is one that falls under the United States Code bankruptcy code.

Discharge of indebtedness when the taxpayer is insolvent

A taxpayer is insolvent when their total liabilities exceed the fair market value of all of their assets. For example, if a taxpayer has $100,000 in liabilities, but only $75,000 in assets, they are considered insolvent under the Internal Revenue Code. Therefore, a cancellation of a $20,000 debt will not need to be reported as gross income. However, if a debt of $30,000 was cancelled, the taxpayer will still have $5,000 in gross income, as the $30,000 debt forgiveness exceeded their insolvency. The criteria for the insolvency exclusion are considerably stricter than those used under bankruptcy law, as the asset counted for the insolvency exemption includes retirement accounts, which are generally excluded by law in bankruptcy.

A qualified purchase price reduction given by a seller

Sometimes a price agreement will be reached between buyer and seller, but for some reason both parties agree to reduce that price at a later date. If a reduction in price occurs after they have already reached an agreement, the IRS treats the new agreed-upon price as if it were the original price, which means there will not be COD income to the buyer.

If the indebtedness discharged is qualified farm indebtedness

A taxpayer has qualified farm indebtedness if such indebtedness was incurred directly in connection with the taxpayer's trade or business in farming; and 50 percent or more of the aggregate gross receipts of the taxpayer for the three taxable years preceding the discharge is attributable to the trade or business of farming.

If the indebtedness discharged is qualified real property business indebtedness

Qualified real property business indebtedness includes debt incurred or assumed by the taxpayer in connection with real property used in a trade or business and which is secured by such real property; was either incurred or assumed prior to Jan. 1, 1993, or incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property; and the taxpayer elects to apply this exception.

Cancellation of certain qualified student loans

Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. To qualify, the loan must have been made by the federal, state or local government (or agency or subdivision thereof); or an educational institution.

Cancellation of qualified principal residence indebtedness

For tax years beginning before 2014, there was an exclusion for "qualified principal residence indebtedness" which provided significant relief for COD for homeowners involved in the mortgage foreclosure crisis. Under current law, the exclusion is not available for tax years after 2013.

Generally, if you exclude canceled debt from income under one of the exclusions listed above, you must reduce your positive tax attributes (certain tax credits, net operating losses, basis of assets, etc.), within limits, by the amount excluded. You do this by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to report the amount qualifying for exclusion and any corresponding reduction of certain tax attributes. The reductions in tax attributes are dollar-for-dollar to the amount of excluded COD income for the NOL, capital loss carryover, and basis reductions. For tax credit carryovers, the reductions in tax attribute are 33 1/3 cents-for-dollar.

There are special rules for partnerships and S-Corporations. For partnerships and LLCs, COD is treated as an item that is proportionally passed through to its partners, and the various exclusions are applied at the individual partner level. While COD is applied at the S-Corporation level, S Corporations do not have NOLs. Instead, the concept of reducing tax attributes is handled at the shareholder level. Each shareholder must treat any loss or deduction that exceeds their stock and debt basis as a suspended (disallowed) loss, which carries forward indefinitely until applied toward future earned income earned by the S Corporation

Dealing with the consequences of debt forgiveness in the recent economy is hard enough. The above is only a summary of the rules involved, and as with most complicated tax matters, you should seek the advice of a CPA or attorney for advice on the proper treatment and elections to help minimize the impact of COD income.

For additional information, refer to IRS Publications 4681 and 525.

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Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP, and can be reached at Bspeer@mmb-co.com or (585) 423-1860.

Published: Mon, Dec 29, 2014