Cancellation of Debt Income - The Bad News and the Good

In the course of the current recession, there are many sad stories, but perhaps few quite so sad as the stories of those who have rejoiced in their success at convincing lenders to forgive indebtedness, only to find that the debt that was forgiven then gives rise to an unforeseen tax liability. In this era of increased bankruptcy, mortgage modifications, and short-sales, it is important to understand the tax consequences of forgiveness of debt before marching down the road. This article will briefly outline the problem, and will map out several solutions.

The definition of “income’ under the Internal Revenue Code includes deemed income from the forgiveness of debt. Therefore, if you are liable upon a promissory note for $150,000, and you succeed in getting the holder of the note to accept $50,000 in full payment, you will be deemed to have received taxable income in the amount of $100,000. There are several important exceptions.

Bankruptcy . Debt that is the subject of a discharge in a Bankruptcy proceeding is, under the terms of the Code, not taxable. So, if you are a debtor in a straight (Chapter 7) or Chapters 11 or 13 bankruptcy proceeding, you will not need to pay taxes on the “forgiven” income. Note that the income should be counted and will usually be reported on a Form 1099, but it will be excluded on a supplemental Form 982.

Principal Residence. The second, and increasingly significant exception is the discharge of qualified principal residence indebtedness. In order to qualify for this exclusion, the debt must, first, be securing the taxpayer’s principal residence. This exclusion is also limited to a mortgage securing the amount incurred to buy, build or substantially improve the principal residence. Debt that is used to refinance the qualified principal residence indebtedness is eligible for this treatment but only up to the previous mortgage principal just before the refinancing. Any debt used to substantially improve the principal residence is also treated as qualified principal residence indebtedness. For example, if Taxpayer buys a home in 1999 and finances it for $200,000; then takes out a home equity loan to build an addition for $50,000; subsequently refinances the outstanding $250,000 with a new mortgage for $300,000; then the home is sold in a short-sale for $200,000, with the lender forgiving the $100,000 shortfall, the amount excluded under this provision is the excess of the amount forgiven over the amount of the non-qualified loan amount, or, here, $50,000. So, in this example, only one-half of the forgiveness of debt income is freed by this provision from tax liability.

Note also that the maximum indebtedness that an individual taxpayer can exclude under this provision is $2,000,000 ($1,000,000 if the taxpayer is married and filing separately), and the exclusion applies only to debt discharged during the years 2007 through 2012, inclusive.

Business Real Property. Next, there is also an exclusion for qualified real property business debt, to the extent the outstanding principal balance of the debt exceeds the fair market value of the business property immediately before the discharge.

Insolvency. It may be left to the fourth exception to help out the taxpayer, above. The third major exclusion is for debt forgiven while the taxpayer is based upon the taxpayer being insolvent at the time of the forgiveness of debt. The exclusion applies only to the extent of the insolvency; i.e., the extent to which the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets, immediately before the forgiveness of debt. Thus, if a debtor is forgiven a $100,000 loan, and liabilities prior to the forgiveness exceed his assets by $40,000, only $40,000 will be excluded from taxable income. There is an insolvency worksheet on the IRS publication 4681.

Timing. It is worth bearing in mind that when a taxpayer has multiple debts, and begins an effort to settle these obligations, the timing of the settlements may become significant, in that the earlier settlements may have the effect of reducing or relieving the insolvency of the taxpayer, such that the later settlements may be effectuated at a point when the taxpayer no longer has full or any recourse to the insolvency exclusion.

Priority of Exclusions. Where a number of these exclusions may apply, the order of application is (a) bankruptcy; (b) insolvency; and then (c) the qualified business property, home mortgage and farm exclusions.

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This article does not discuss the exclusion for qualified farm indebtedness, although it should not be overlooked if it might be applicable.