Cancellation of Debt

4/18/2013 - By John Mascaro, CPA

Not necessarily a cancellation of "tax"

This article will discuss briefly the most common types of tax issues involving the cancellation of debt. Other, more complex issues in this area will be covered in a later article.

So, after several months of wrangling, testy email exchanges and awkward personal meetings where you've dragged along your attorney and CPA, that creditor who by now has become a household name (banker, or seller who took back a purchase money mortgage, or the credit card company, etc) agrees to forgive and formally cancel some or all of the debt you owe them, an issue that has been a thorn in your side for over a year.

Your first reaction is to jump for joy, call the spouse, and plan a celebratory dinner - of course. And that may be an understandable first reaction - after all you will not have to deal with the burdensome principal and interest payments, no more harassing emails, letters and phone calls, you can stop chugging that Pepto-Bismol at lunch, and finally get to do something your friends say is quite an enjoyable pastime - What's that they call it? - Oh yeah, sleep.

Not so fast.

You see, when a loan that you owe is forgiven and cancelled, the amount "forgiven" or cancelled can have rather surprising tax consequences for some people. This results from the way the tax law views such cancellations. The tax law sometimes refers to this forgiveness as a "discharge" of debt - which almost makes it sound like a medical condition! Indeed, for some taxpayers, if they didn't have a medical condition when the debt was forgiven, they might get one once they are told by their tax advisor how the tax law views the forgiveness.

The tax law considers you have received "income" to the extent of the amount you will no longer have to repay.

Ouch! The justification for this treatment stems, in part, from the fact that presumably you've used the proceeds from the loan to derive some economic benefit, including a tax benefit by way of a capitalized cost that is being amortized or depreciated as an expense over time, or obtained a currently deductible expense, or the funds have become part of the cost of property that may offset some portion of any future gain when that property is sold.

Consequently, under those principles, if a lender who provided the funds later forgives your requirement to repay them, the forgiven / cancelled debt is "income" to you at the time of such cancellation. Also, for purposes of COD, "debt" includes not just the principal amount outstanding on your loan, but also accumulated interest.

Oh, and by the way, as you might have figured out by now, you are not receiving any additional cash for this "income" (in effect the cash already came to you by way of the earlier loaned proceeds).

This is why this cancellation of debt - or C.O.D. income - is sometimes called "phantom income".

Because such income must be included in arriving at the computation of your taxable income, unless you have other deductions to offset this phantom income, it will be wholly subject to tax at your effective tax rate for the year.

Are There Exceptions?

Glad you asked. The preceding are the normal rules for the treatment of COD income. But where there's a rule, there are exceptions. The problem is that the exceptions that allow for the cancellation of debt to be excluded from income might mean that you are even in worse shape than you think.

For example, the first exception that allows COD not to be included in income is if you have formally declared "Chapter 11 Bankruptcy" with the Bankruptcy Court.

The second exception is if you are "insolvent" immediately before the COD occurs. For this purpose, "insolvency" is measured as owing more debt than the fair market value of all the assets you own (or that your corporation owns in the debt is corporate debt). In such cases, the amount of COD you may exclude from income is limited to the amount by which you are rendered solvent. Said differently, the insolvency exclusion amount is the amount of canceled debt that exceeds the fair market value of your assets.

Example: The fair market value of your assets is, say, $1 million and you owe $1,500,000 and the bank cancels $500,000 of the debt. In this case the $500,000 cancelled debt is excludable from income under the insolvency exclusion. (See also the interaction of the "taxpayer's principal residence" exception below as it also often applies to insolvencies.)

The third exception is if the COD arose from the discharge of "qualified farm indebtedness". Qualified farm indebtedness, as the name implies, means debt incurred directly in connection with the operation by the taxpayer of the trade or business of farming, AND 50 percent or more of the aggregate gross receipts of the taxpayer for the 3 taxable years preceding the taxable year in which the discharge were in a farming trade or business.

The fourth exception is if the COD arose from "qualified real property business indebtedness". This is a somewhat more complicated exception. Qualified Real Property Business Indebtedness ("QRPBI") generally means debt incurred or assumed by the taxpayer in connection with real property (i.e., real estate) used in a trade or business where the real property secures the debt, ...was incurred or assumed prior to January 1, 1993, or, if incurred or assumed after such date, ...is Qualified Acquisition Indebtedness ("QAI"), AND the taxpayer elects to treat the debt as QRPBI . QAI is debt incurred or assumed to acquire, construct, reconstruct, or substantially improve such property" (i.e. real property used in trade or business and used to secure the debt). For this fourth exception to apply, the taxpayer cannot be a C corporation.

The fifth and last exception is if the COD is related to the taxpayer's principal residence. Up to $2 million of cancelled debt may be excluded for those married filing jointly ($1 million for single taxpayers). For such exception to apply, the debt must be discharged before January 1, 2014.

Generally, where COD is excluded from income, the tax rules require that certain "tax attributes" be reduced instead to avoid a double benefit of income exclusion and a later deduction for such attributes. Tax attributes include the tax cost basis in certain assets, net operating loss and capital loss carryforwards, and various tax credits.

Do you have a debt that may soon be cancelled?

Do you need assistance in negotiating a possible cancellation of debt with your creditor?

Have you improperly reported a prior cancellation of debt on a past tax return?

Does your hair hurt from reading this article and you'd like to sit down with a tax advisor and bring more clarity to your particular situation?

If so, please give us a call at (800) 477-7458. We look forward to helping you assess your options and to advise you on this and any other tax issues you may have.

- John Mascaro, CPA