Reducing or Eliminating the Tax Impact of the Forgiven Debt
What are the tax implications when someone forgives debt that you legally owe? Is the amount forgiven taxable income to you? It really depends on a variety of facts. In this article, we will briefly address some of the things every taxpayer should know about debt forgiveness. If you have been, or expect to be, the recipient of debt forgiveness, for example, you have sold your house in a short sale or are in negotiations with your bank to receive a discount in the amount of your mortgage, you should work closely with your accountant or tax planner to make sure you properly report the transaction and qualify to exclude the debt forgiven from taxable income.
General Rule. If a debt for which a taxpayer is personally liable, recourse debt, is canceled or forgiven, other than as a gift or bequest, the taxpayer must include the canceled amount in income. However, this realized income may be excluded from taxable income if it meets certain requirements.
Examples of Forgiveness of Indebtedness.
Discounts and Loan Modifications. A lender offers a discount for the early payment of the debt or agrees to a loan modification that results in the reduction of the principal balance of the debt. Sale or Other Disposition (Repossession or Foreclosure) – Recourse Debt. If the taxpayer's property was subject to a recourse debt greater than the Fair Market Value (FMV) of the property, and the lender forgives all or part of the amount of the debt in excess of the FMV of the property, the foreclosure or repossession of the property may result in ordinary or capital gain income. The amount of the gain is the difference between the FMV of the property at the time of the disposition and the taxpayer's adjusted basis (usually the cost) in the property. The character of the gain (ordinary or capital) is based on the character of the property that is foreclosed. How Can a Taxpayer Exclude the Realized Income From Taxable Income? Qualified Principal Residence Indebtedness. The taxpayer can exclude canceled debt from income if it is qualified principal residence indebtedness, before January 1, 2013. IRC Section 108(a)(1)(E). Definition. Qualified principal residence indebtedness is any debt incurred in acquiring, constructing, or substantially improving the taxpayer's principal residence and which is secured by the taxpayer's principal residence. This includes debt secured by the taxpayer's principal residence resulting from the refinancing of debt incurred to acquire, construct, or substantially improve the taxpayer's principal residence but only to the extent the amount of debt does not exceed the amount of the refinanced debt. Principal Residence. The taxpayer's principal residence is the home where he or she ordinarily lives most of the time. While the taxpayer can have only one principal residence at any one time, IRC Section 108(h)(5) refers to IRC Section 121 for the definition of principal residence. This may expand the properties that can qualify as a principal residence. Basis Reduction. If the taxpayer excludes the canceled qualified principal residence indebtedness from income and continues to own the residence after the cancellation, the taxpayer must reduce the basis of the residence (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Exclusion Limit. The maximum amount the taxpayer can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). The taxpayer cannot exclude canceled qualified principal residence indebtedness from income if the cancellation was for services performed for the lender or on account of any other factor not directly related to a decline in the value of the taxpayer's residence or to the taxpayer's financial condition. Qualified Real Property Business Indebtedness. Taxpayers (other than C corporations) may elect to exclude from gross income certain income from discharge of qualified real property business indebtedness. The amount excluded is treated as a reduction in the taxpayer's basis of certain depreciable real property and cannot exceed the basis of that property. Code Section 108(c). Definition. Qualified Real Property Business Indebtedness means indebtedness which: was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property;was incurred or assumed before January 1, 1993, or if incurred or assumed on or after such date; is qualified acquisition indebtedness, and with respect to which such taxpayer makes an election to have this paragraph apply. It does not include Qualified Farm Indebtedness. Basis Reduction. The amount excluded from gross income shall be applied to reduce the basis of the depreciable real property of the taxpayer. Exclusion Limitation. The amount excluded shall not exceed the excess (if any) of: the outstanding principal amount of such indebtedness (immediately before the discharge), over the fair market value of the real property reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property (as of such time). Overall, the excluded amount shall not exceed the aggregate adjusted bases of depreciable real property (determined after any reductions under IRC Sections 108 (b) and (g)) held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of such discharge). Insolvency. If the taxpayer is insolvent immediately before the debt cancellation, he can elect to apply the insolvency exclusion instead of applying the qualified principal residence indebtedness exclusion. He is insolvent to the extent that all of the his liabilities exceed the FMV of all of his assets immediately before the cancellation. IRC Section 108(a)(1)(B). The debt discharged that exceeds his level of insolvency is included in income. For example, if the debtor has $500,000 in debt, $350,000 in assets and receives a discharge of indebtedness of $200,000, he may exclude from income $150,000 of the indebtedness discharged and, unless excluded for another reason, treat the remaining $50,000 as income. Bankruptcy. Debt canceled in a Title 11 bankruptcy case is not included in the taxpayer's income, but only if the debtor is 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. IRC Section 108(a)(1)(A). The QPRI exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case. If qualified principal residence indebtedness is canceled in a title 11 bankruptcy case, the taxpayer must apply the bankruptcy exclusion rather than the exclusion for qualified principal residence indebtedness. Reduction of Tax Attributes. If the taxpayer excludes canceled debt from income, he must reduce certain tax attributes (certain credits, losses, and basis of assets) by the amount excluded, but not below zero. IRC Section 108(b). The order in which the tax attributes are reduced depends on the reason the canceled debt was excluded from income. IRC Section 108(b)(2), (4) and (5).