Sometimes debts can pile up beyond a borrower’s ability to repay, especially if we are heading into a recession.
But lenders are sometimes willing to cancel (forgive) debts that are owed by financially challenged borrowers.
While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event.
This analysis summarizes the most important federal income tax implications when debts are canceled.
General Rule: COD Income Is Taxable
When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs.
Fortunately, there are a number of exceptions to the general rule that COD income is taxable. You can find the exceptions in Section 108 of our beloved Internal Revenue Code, and they are generally mandatory rather than elective.
Lenders Should Report COD Income to Borrowers and the IRS
In theory, lenders are required to report COD income amounts to borrowers in box 2 of Form 1099-C (Cancellation of Debt) for the year the debt cancellation occurs.
· Any accrued but unpaid interest included in the box 2 amount should be reported separately in box.
· The date of the COD event should be reported in box 1, and there’s a box that is supposed to be checked if the borrower was personally liable for the canceled debt.
In the real world, Form 1099-C is sometimes issued for the wrong year or not at all. Amounts and other information reported on Form 1099-C (such as the borrower’s address) are sometimes wrong. In other words, lender compliance with Form 1099-C filing and reporting requirements can be hit or miss. Shocking!
Beneficial Exceptions Grant Tax-Free Treatment to Eligible Borrowers
Here’s a list of exceptions to the aforementioned general rule that COD income is taxable. These exceptions can be big tax-saving deals, so get to know them!
COD income from debt cancellations that are granted in Title 11 bankruptcy proceedings are automatically excluded from the borrower’s gross income.
At first glance, such debt cancellations appear to be federal-income-tax-free. But as we will explain later, the borrower may have to reduce certain tax attributes—such as net operating losses (NOLs), capital loss carryovers, and tax credit carryovers—as the price to be paid for benefitting from this exception.
Key point. Title 11 of the U.S. Code is not part of our beloved Internal Revenue Code. Title 11 covers bankruptcies filed under Chapter 7 (so-called liquidations), Chapter 11 (so-called reorganizations), Chapter 12 (for farmers and fishermen), and Chapter 13 (so-called wage earner filings).
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made it harder for individuals to file under Chapter 7 and thereby get completely off the hook for unsecured debts. But COD income can still occur in some Chapter 7 cases, as well as in Chapter 11, 12, and 13 cases.
When an insolvent borrower (as opposed to the bankrupt borrower) has COD income, it’s excluded from gross income to the extent of the borrower’s insolvency immediately before the COD transaction. “Insolvent” means the borrower’s liabilities exceed the fair market value of the borrower’s assets.
Any COD income in excess of the amount of insolvency immediately before the debt cancellation transaction generates an equal amount of gross income. Put another way, debt discharge that causes the borrower to become solvent must be included in the borrower’s gross income.
Therefore, determining the amount of the borrower’s insolvency immediately before a debt cancellation transaction is crucial. And as we will explain later, the borrower may have to reduce certain tax attributes as the price to be paid for benefitting from the insolvency exception.
Under applicable law, some personal assets are generally off-limits for creditors. We will call those assets “exempt assets.” Unfortunately, the Tax Court has agreed with the IRS position that exempt assets should be included as assets in the insolvency calculation.
When calculating insolvency, count a non-recourse debt as a liability only to the extent of the fair market value of the property that secures the liability. Treat any excess non-recourse debt (above the fair market value of the security) as a liability only to the extent it is canceled by the lender. Otherwise, ignore excess non-recourse debt in making the insolvency calculation.
Spouse’s Separate Property
In making the borrower’s insolvency calculation, do not take into account any assets that are separate property of the borrower’s spouse. Follow this rule even if the spouses file joint tax returns.
Bankruptcy Exception Takes Precedence over Insolvency Exception
When debt cancellation occurs in bankruptcy proceedings, the bankruptcy exception takes precedence over the insolvency exception. So, the bankruptcy exception rules must be followed.
How to Reduce Tax Attributes after Benefitting from the Bankruptcy or Insolvency Exception
The cost of being allowed to exclude COD income from taxation under the bankruptcy or insolvency exception is a reduction of the borrower’s so-called tax attributes.
You generally reduce these tax attributes (future tax benefits) by one dollar for each dollar of excluded COD income. But you reduce tax credits by one dollar for each three dollars of excluded COD income. You reduce these attributes only after calculating your taxable income for the year the debt cancellation occurs.
Follow Ordering Rule to Reduce Attributes
Reduce the following tax attributes (but not below zero) in the order described.
1. Net operating losses. Reduce any NOL generated in the tax year of the debt cancellation, and then reduce any NOL carried into that year. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.
2. General business credits. Reduce any credit carryover to/from the year of the debt cancellation. Reduce the credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.
3. Minimum tax credits. Reduce credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.
4. Capital loss carryovers. Reduce any capital loss carryover arising in the year of the debt cancellation, and then reduce any capital loss carryover into that year. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.
5. Tax basis of property. Reduce basis under the rules set forth in Section 1017 of the Internal Revenue Code and related regulations. Do the reductions after calculating the borrower’s depreciation deductions for the year of the debt cancellation.
6. Passive activity losses and credits. Reduce any loss or credit carryover from the year of the debt cancellation. Reduce credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.
7. Foreign tax credits. Reduce any credit carryover to/from the year of the debt cancellation. Reduce credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.
Consider Basis Reduction Options
Instead of reducing tax attributes in the order specified above, the borrower can elect to first reduce the basis of depreciable property. Then any remaining excluded COD income (after what’s absorbed by the basis reduction) reduces the borrower’s other tax attributes in the order specified above.
Borrowers who make this basis-reduction election can make another election to treat real property inventory as depreciable property for purposes of the basis-reduction election.
Key point. Making these basis-reduction elections can help a borrower who has NOL carryovers or other valuable tax attributes that the borrower expects to utilize in the relatively near future. But making these elections will reduce future depreciation deductions, and it will increase taxable gains or reduce taxable losses when affected assets are sold. So, these elections are not a free lunch.
Follow Favorable Timing Rule for Attribute Reductions
As mentioned earlier, any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.
Key point. This taxpayer-friendly rule allows the borrower to take full advantage of any tax attributes available for the year of the debt cancellation before those attributes are reduced.
Principal Couer d’Alene Residence Mortgage Debt Exception
A temporary exception created years ago and then repeatedly extended by Congress applies to COD income from qualifying cancellations of Couer d’Alene Idaho home mortgage debts that occur through 2025.
Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income—or $375,000 if the borrower uses married-filing-separately status—from the cancellation of qualified principal residence indebtedness. That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.
Refinanced debt can qualify to the extent it replaces debt that was used to acquire, build, or improve the borrower’s principal Couer d’Alene residence.
You reduce the tax basis of the principal residence (but not below zero) by the amount of COD income excluded from taxation under this exception. You don’t reduce any of the borrower’s other tax attributes.
Finally, an insolvent borrower can elect to forgo this exception and instead rely on the more general insolvency exception explained earlier.
Warning. This exception applies only to COD income from the cancellation of mortgage debt that was used to acquire, build, or improve a principal residence. Discharges of home equity loans used for other purposes won’t qualify for this exception, nor will discharges of vacation home loans or investment property loans. But other exceptions covered in this analysis may be available in those circumstances.
Deductible Interest Exception
To the extent COD income is from accrued but unpaid interest that was added to the loan principal and then canceled, that amount of COD income is federal-income-tax-free if the borrower could have deducted the interest that would have been paid. The borrower’s tax attributes are unaffected.
Seller-Financed Debt Exception
COD income from the cancellation of debt that was owed to the previous owner of seller-financed property is federal-income-tax-free. The tax-free amount reduces the borrower’s tax basis in the related property.
In effect, this treatment amounts to a retroactive purchase price reduction. The borrower’s other tax attributes are unaffected. This exception is unavailable when the debt cancellation occurs in bankruptcy proceedings or when the borrower is insolvent.
Qualified Real Property Business Indebtedness Exception
COD income from the cancellation of qualified Coeur d’Alene real property business indebtedness is federal-income-tax-free.
Qualified CDA real property business indebtedness is debt (other than qualified farm debt) that meets all of the following conditions:
· The debt was incurred or assumed in connection with real property used in a trade or business—not including real property that is developed and held primarily for sale to customers in the ordinary course of business. (Residential rental property generally qualifies as real property used in a trade or business, unless the property has also been used as the borrower’s home.)
· The debt is secured by such real property.
· The debt is qualified acquisition indebtedness.
· The borrower makes the election for this exception to apply.
· The COD amount excluded from taxation income under this exception reduces the tax basis of the borrower’s depreciable real property. The borrower’s other tax attributes are unaffected.
This exception is not available to debt cancellations that occur in bankruptcy proceedings, and it is not available to C corporations.
Finally, this exception is not available to the extent the insolvency exception is available to the borrower.