Taxable Income From Cancellation of Debt and Important Exceptions

Discharge of Indebtedness Income and Exceptions

Generally when a person has a debt discharged, such an event triggers taxable income.  For example, where a person owes $50,000 and the lender agrees to take only $30,000 to satisfy the debt, the borrower has taxable income of $20,000.

If property that is repossessed or foreclosed on secures a debt for which the borrower is personally liable (so called “recourse debt’), the borrower must generally report as ordinary income the amount by which the cancelled debt exceeds the FMV of the property.

Example:  Borrower is personally liable for $100,000 on a loan that is secured by property that is worth $75,000.  Lender takes back the property and fully discharges the borrower.  Borrower has $25,000 of discharge of indebtedness income.

It is important to note that this income is separate and apart from any gain or loss realized from the repossession.  This gain or loss on the transfer of the property must be calculated separately.  So following the above example assume the borrower had a basis in the property was $40,000.  Under this scenario, the borrower would have a capital gain of $35,000, the difference between the amount realized, $75,000, less his basis of $40,000.

Exceptions

In the following situations, income from the cancellation of debt in not taxed.  Here are some of the exceptions for discharge of indebtedness income:

Insolvency

Qualified Principal Residence Indebtedness (QPRI)

There is a second exclusion called qualified principal residence indebtedness (QPRI) for discharges of up to a $2 million dollar.

To meet the QPRI you must meet 3 parts:

For more on this topic please go my article entitled Mortgage Debt Discharge of Primary Residence

Discharge of Debt Through Bankruptcy

When the forgiveness of debt occurs in a bankruptcy case, Internal Revenue Code section 108(a)(1)(A) specifically provides that it is not to be treated as income. Thus, discharge of a debt through a bankruptcy proceeding is excluded from gross income for tax purposes.

Gift

There is no discharge of indebtedness income where the cancellation is intended as a gift.  This is very factually sensitive issue that will apply in only certain situations.

Other Exceptions To Discharge Indebtedness Income

Here are some other specialized exceptions to discharge of indebtedness income:

1. Qualified real property business debt
2. Qualified farm debt
3. Qualified Midwestern disaster area debt

Filing Tip

Be sure to account for all Form 1099s you receive, even if you have completed a bankruptcy proceeding.  This is accomplished by reporting the income from cancellation of non-business debt as “Other income” on Line 21 of the Form 1040 and by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, where applicable.

Warning

The above discussion is only an overview of these tricky and often times confusing tax rules.  Please contact our office for guidance as to the impact of these rules and the tax return aspects of reporting such transactions properly.