11.8 Cancellation of Debts You Owe
If a debt is cancelled or forgiven other than as a gift or a bequest the debtor generally must include the cancelled amount in gross income for tax purposes. Exclusions are allowed for discharges of farm or business real estate debt and debts of insolvent and bankrupt persons. If qualified principal residence indebtedness of up to $2 million is discharged before 2013 as part of a mortgage restructuring or foreclosure, the discharge is excluded from income. Details on the exclusion for qualified principal residence indebtedness as well as the other exclusions are provided below.
If you qualify for one of the exclusions, you generally must reduce certain “tax attributes” (such as the basis of property) by the amount excluded. The reduction of tax attributes is made on Form 982.
Form 1099-C.
You should receive Form 1099-C from a federal government agency, credit union, or bank that cancels or forgives a debt you owe of $600 or more. The IRS receives a copy of the form. Generally, the amount of cancelled debt shown in Box 2 of Form 1099-C must be reported as “other income” on Line 21 of Form 1040, unless one of the exclusions discussed below applies.
Mortgage loan “workouts” and repayment discounts.
If your lender agrees to a “workout” that restructures your loan and reduces the principal balance of your debt, or you are allowed a discount for paying off your loan early, the debt reduction or discount is considered cancellation of debt income if you retain the collateral (31.10). If it is considered a cancellation of debt, report it on Line 21 of Form 1040 unless you can exclude the debt from income under the exclusion for qualified principal residence indebtedness or one of the other exclusions discussed below.
Caution
Foreclosure, repossession, or voluntary conveyance.
If a lender forecloses on a loan secured by your property (such as your home mortgage) or repossesses the property secured by the loan (such as your car), or you voluntarily convey the property to the lender, the transaction is treated as a sale on which you realize gain or loss, as explained in 31.9.
In addition, if you are personally liable on the loan (recourse debt) and the amount of the debt cancelled by the lender exceeds the fair market value of the property, you have cancellation of debt income that must be reported as ordinary income unless one of the exclusions discussed below applies. The lender will report fair market value of the property in Box 7 Form 1099-C.
Cancellation of student loans.
The cancellation of a student loan results in taxable income unless one of the following exceptions applies.
If a loan by a government agency, by a government-funded loan program of an education organization, or by a qualified hospital organization is cancelled because you worked for a period of time in certain geographical areas in certain professions, such as practicing medicine in rural areas or teaching in inner-city schools, then the cancelled amount is not taxable. The IRS has ruled that the exception also applies to law school graduates who have student loan indebtedness forgiven under the Loan Repayment Assistance program if they work for a specified period of time in law-related public service positions in government or with tax-exempt charitable organizations. If a loan from an educational organization is cancelled because you work for that organization, the exclusion from gross income does not apply; the cancellation is taxable unless some other exclusion applies.
There is also a special exclusion for healthcare professionals who have student loans forgiven or repaid to them because they work in underserved communities. For 2009 and later years, the exclusion includes loans forgiven or repaid under any state program that is intended to increase the availability of healthcare services in underserved areas. Previously, the exclusion for health professionals was limited to debt forgiven or repaid under the National Health Services Corps Loan Repayment Program or under state loan repayment programs eligible for funding under the Public Health Service Act.
Law Alert
Exclusion for discharge of qualified principal residence indebtedness.
For years before 2013, the discharge of up to $2 million of qualified principal residence indebtedness may be excluded from gross income; see the e-Supplement for an update on the possible extension of the exclusion beyond 2012.
The exclusion includes a cancellation in the course of a mortgage loan modification (“workout”) or a foreclosure. Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving your principal residence and which is secured by your principal residence. It also includes debt secured by your principal residence that refinances debt incurred to acquire, construct, or substantially improve your principal residence, but only to the extent of such refinanced debt. If part of the cancelled debt is not qualified principal residence indebtedness, such as refinancing used to pay personal expenses, that part must be included in income, unless another exception applies, such as the insolvency exclusion; see the Nancy Oak example below.
The maximum exclusion for cancelled qualified principal residence indebtedness is $2 million, or $1 million if filing separately. If you had several cancellations of qualified principal residence indebtedness, the $2 million/$1 million limit applies to all cancellations occurring in 2007 through 2012.
You claim the exclusion for cancelled qualified principal residence indebtedness on Form 982 by checking the box on Line 1e and entering the excluded amount on Line 2. If you continue to own the residence after the cancellation of debt, then on Line 10b of Form 982 you must reduce your basis in the residence by the excluded amount. However, if the qualified principal residence indebtedness is cancelled in a Title 11 bankruptcy case, the bankruptcy exclusion (see below) must be applied and not the exclusion for discharge of qualified principal residence indebtedness. Check the box on Line 1a of Form 982 (discharge in Title 11 case) rather than the box on Line 1e.
If your cancelled debt is qualified principal residence indebtedness and you also were insolvent immediately before the debt cancellation because your liabilities exceeded the fair market value of your assets, you can elect to apply the insolvency exclusion (see below) instead of the exclusion for qualified principal residence indebtedness. If only part of the cancelled debt is qualified principal residence indebtedness, you can claim the qualified principal residence indebtedness exclusion for the qualifying portion and, to the extent of your insolvency, the insolvency exception can be applied to the nonqualified debt.
The following example illustrates application of the exclusion for discharges of qualified principal residence indebtedness. It is based on an example from IRS Publication 4681 (Canceled Debts, Foreclosures, Repossessions, and Abandonments), which also has other detailed examples on the exclusion for qualified principal residence indebtedness.
Debts cancelled in bankruptcy.
Debt cancelled in a Title 11 bankruptcy case is not included in your gross income if the cancellation is granted by the court or under a plan approved by the court. Instead, certain losses, credits, and basis of property must be reduced by the amount excluded from income. These losses, credits, and basis of property are called “tax attributes.” The amount of cancelled debt is used to reduce the tax attributes in the order listed below:
After these reductions, any remaining balance of the debt discharge is disregarded. On Form 982, you may make a special election to first reduce the basis of any depreciable assets before reducing other tax attributes in the order above. Realty held for sale to customers may be treated as depreciable assets for purposes of the election. The election allows you to preserve your current deductions, such as a net operating loss carryover or capital loss carryover, for use in the following year. The election also will have the effect of reducing your depreciation deductions for years following the year of debt cancellation. If you later sell the depreciable property at a gain, the gain attributable to the basis reduction will be taxable as ordinary income under the depreciation recapture rules (44.1).
Debts discharged while you are insolvent.
If your debt is cancelled outside of bankruptcy while you are insolvent, the cancellation does not result in taxable income to the extent of the insolvency. Insolvency means that liabilities exceed the fair market value of your assets immediately before the discharge of the debt. IRS Publication 4681 has a worksheet you can use to determine whether you were insolvent immediately before the debt discharge and the extent of the insolvency. The IRS and Tax Court hold that in determining whether liabilities exceed the value of assets at the time of a debt discharge, a taxpayer must include assets that are shielded from creditors under state law. This is true even though for federal bankruptcy purposes creditor-exempt assets do not have to be counted in determining whether an individual seeking bankruptcy protection is insolvent.
Court Decision
If liabilities do exceed the value of assets, the discharged debt is not taxed to the extent of your insolvency and is applied to the reduction of tax attributes on Form 982 in the same manner as to a bankrupt individual. If the cancelled debt exceeds the insolvency, any remaining balance is treated as if it were a debt cancellation of a solvent person and, thus, it is taxable unless another exclusion is available as discussed in this section.
See the Example below for the IRS approach to figuring insolvency upon a debt cancellation.
Partnership debts.
When a partnership’s debt is discharged because of bankruptcy, insolvency, or if it is qualified farm debt or business real estate debt that is cancelled, the discharged amount is allocated among the partners. Bankruptcy or insolvency is tested not at the partnership level, but separately for each partner. Thus, a bankrupt or insolvent partner applies the allocated amount to reduce the specified tax attributes as previously discussed. A solvent partner may not take advantage of the rules applied to insolvent or bankrupt partners, even if the partnership is insolvent or bankrupt.
S corporation debts.
The tax consequences of a debt discharge are determined at the corporate level. A debt discharge that is excludable from the S corporation’s income because of insolvency or bankruptcy does not pass through to the shareholders and thus does not increase the shareholders’ basis.
Purchase price adjustment for solvent debtors.
If you buy property on credit and the seller reduces or cancels the debt arising out of the purchase, the reduction is generally treated as a purchase price adjustment (reducing your basis in the property). Since the reduction is not treated as a debt cancellation, you do not realize taxable income on the price adjustment. This favorable price adjustment rule applies only if you are solvent and not in bankruptcy, you have not transferred the property to a third party, and the seller has not transferred the debt to a third party, such as with the sale of your installment contract to a collection company.
Qualified farm debt.
A solvent farmer may avoid tax from a discharge of indebtedness by an unrelated lender, including any federal, state, or local government agency, if the debt was incurred in operating a farm business. This relief is available only if 50% or more of your total gross receipts for the preceding three taxable years was derived from farming. The excluded amount first reduces tax attributes such as net operating loss carryovers and business tax credits, next reduces basis in all property other than farmland, and then reduces the basis in land used in the farming business. See IRS Publication 4681 for details.
Filing Instruction
Business real estate debt.
A solvent taxpayer may elect on Form 982 to avoid tax on a discharge of qualifying real property business debt. Such a discharge may occur where the fair market value of the property securing the debt has fallen in value. The debt must have been incurred or assumed in connection with business real property and must be secured by such property. A debt incurred or assumed after 1992 must be incurred or assumed to buy, construct, or substantially improve real property used in a business, or to refinance such acquisition debt (up to the refinanced amount). Debt incurred after 1992 to refinance a pre-1993 business real property debt (up to the refinanced amount) also qualifies. The debt must be secured by the property. Discharges of farm indebtedness do not qualify but may be tax free under the separate rules discussed earlier.
The maximum amount that can be excluded from income is the excess of the outstanding loan principal (immediately before the discharge) over the fair market value (immediately before the discharge) of the real property securing the debt, less any other outstanding qualifying real property business debts secured by the property. The excludable amount also may not exceed the taxpayer’s adjusted basis for all depreciable real property held before the discharge. On Line 4 of Form 982, you reduce your basis in all your depreciable real property by the excluded amount.
Effect of basis reduction on later disposition of property.
A reduction of basis is treated as a depreciation deduction so that a profitable sale of the property at a later date may be subject to the rules of recapture of depreciation (44.1).