Thigpen, Jones, Seaton, & Co

Canceled Debt: Is It Taxable?

By Josh Gardner, CPA on January 16th, 2012

In these tough economic times, many taxpayers and practitioners are having to deal with an issue they have seldom seen in the past – cancellation of debt.  This article is intended to be a basic overview of the rules surrounding the more common cancellation of debt situations.

In general, if you receive a Form 1099-C from a creditor, you must report the indicated amount as ordinary income on your return.  However, if you meet a certain exception or exclusion, you do not have to include the canceled debt in income. The following are the common exceptions and exclusions:

Exceptions

1. Amounts specifically excluded from income by law such as gifts or bequests
2. Cancellation of certain qualified student loans
3. Canceled debt that if paid by a cash basis taxpayer is otherwise deductible
4. A qualified purchase price reduction given by a seller

          Exclusions

1. Debt canceled in a Title 11 bankruptcy case – you must be under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
2. Debt canceled due to insolvency- If you are insolvent immediately before a debt is canceled, the canceled debt can be excluded from income to the extent you are insolvent.  You are considered insolvent if the fair market value of all your assets is less than your total liabilites.  For example, if you have assets worth $10,000 and debt totaling $20,000, you are insolvent to the extent of $10,000 and can exclude canceled debt up to $10,000.
3. Cancellation of qualified farm indebtedness – you can exclude canceled farm debt from income if all of the following apply:
• The debt was incurred directly in connection with the operation of your farm.
• 50% or more of your total gross receipts for the three previous years prior to the current taxable year were from the trade or business of farming
• The cancellation of was made by a qualified person. A qualified person is an individual, organization, partnership, association, corporation, etc., who is actively and regularly engaged in the business of lending money.
4. Cancellation of qualified real property business indebtedness – real property (a.ka. real estate) is land and generally anything built on or attached to it. Qualified real property business indebtedness is debt that was incurred or assumed in connection with real property used in a trade or business and is secured by that real property.
5. Cancellation of qualified principal residence indebtedness – canceled debt from your home mortgage can be excluded from income, assuming the mortgage was used to buy, build, or substantially improve your home

Generally, if you exclude canceled debt from income for one of the above exclusion reasons, you must also reduce certain tax attributes (certain credits, losses, and basis of assets).

If a lender forecloses on your loan and repossesses the property, it is treated as a deemed sale from which you may realize gain or loss.  If the outstanding loan balance was more than the fair market value of the property and the lender cancels all or part of the remaining loan balance, you also may realize ordinary income from the cancellation of the debt.  You must report this income on your return unless certain exceptions or exclusions apply.

Please contact us if you have had debt canceled and we will be glad to address the tax implications as it relates to your particluar situation.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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