Debt forgiveness poses income tax ramifications
In these troubled economic times, many financially distressed borrowers have had debt cancelled or forgiven by their lender. Forgiveness of debt can take on many different forms, including a “short sale;” the foreclosure of a home, business or investment property; the adjustment of a debt outside of foreclosure; or even the forgiveness of amounts owed to a credit card company.
While debt relief was no doubt welcome news to the people who received it, they might not realize the amount of the forgiven debt could have to be included in income when it comes time to file their income tax returns.
The “general tax rule” requires taxpayers to include income from the cancellation of indebtedness in gross taxable income. However, anytime a taxpayer has a debt forgiven or canceled and/or receives a 1099-C form from a lender, there are several steps they could take to minimize the tax consequences.
First, the taxpayer should evaluate the various exceptions that exist within the tax code. Exceptions to reporting cancellation of debt income are as follows:
Bankruptcy. Debt canceled in a Title 11 bankruptcy is generally not included in income. A Title 11 bankruptcy would include bankruptcies filed under Chapters 7, 11 or 13 of Title 11.
Insolvency. Debtors don’t include a canceled debt in income to the extent they were “insolvent” immediately before the cancellation. Insolvency is generally defined as the total of all liabilities exceeding the fair market value of all assets.
Qualified farm indebtedness. Debtors can exclude canceled farm debt from income if the debt was incurred directly in connection with the trade or business of farming and various other rules are met.
Qualified real property business indebtedness. A solvent debtor can exclude canceled debt if it is debt to acquire qualified business real property.
Qualified principal residence indebtedness. Individuals can exclude canceled debt if it is debt incurred in acquiring, constructing or substantially improving a “principal residence” and the debt it secured by that residence. The maximum amount an individual can exclude using this exception is $2 million. The individual must then reduce the original cost basis of the residence by the amount of the canceled debt.
Certain student loans. Doctors, nurses and teachers who agree to work in rural or low-income areas in exchange for cancellation of their student loans won’t have income from the cancellation if they meet certain conditions.
Secondly, the taxpayer should determine whether or not the loan could be re-characterized.
If the loan was from a related family member, for example, perhaps the debt discharge was intended as a tax-free gift to the borrower. Or, if the loan was between a shareholder and related corporation, perhaps the debt discharge could be re-characterized as something other than debt discharge. In addition, a purchase price adjustment is not considered a cancellation of a debt. There is no income if an individual purchases property and the seller later reduces the price. Instead, the purchaser’s basis is reduced by the amount of the purchase-price adjustment.
Thirdly, taxpayers should keep in mind there’s no income from cancellation of a debt that was deductible. For example, if a lender cancels interest that could have been claimed as a deduction, there is no tax problem with which to contend.
Fourth, where there is a debt discharge that’s excluded from income, there are often additional ramifications, including reduction of tax attributes or reduction in the basis of other property. There are options and consequences here that require specific knowledge to obtain the best results.
Finally, taxpayers receiving a 1099-C from a foreclosure should closely scrutinize the fair market value (FMV) of foreclosed property listed in Box 7. In some situations, a lower FMV could produce a better tax result. In other situations, a higher FMV could be a benefit.
People who have been involved in a debt forgiveness transaction or are contemplating one should seek qualified advice to determine how the transaction could affect their taxes, gain the maximum advantage from any exception or exclusion that might apply and better consider the various choices that could be available.