Cancellation of Debt Part Two: Exceptions to the Rule

7/6/2017 - By John Mascaro, CPA

In my last blog, I discussed the “normal” tax consequences of having a debt canceled by your creditor. But, there are exceptions to the “norm.” These exceptions do allow for the forgiven debt to be “erased” from your income; however, this exclusion from income could reveal that you are even in worse shape than you thought! 

Let’s discuss the six primary exceptions for your canceled debt.

Are you bankrupt? If you have formally declared “Chapter 11 Bankruptcy” with the Bankruptcy Court, then your canceled debt won’t be included in your income.

Were you “insolvent”?  The second exception is if you are “insolvent” immediately before the COD occurs.  Insolvency is measured as owing more debt than the fair market value of all the assets you own (or that your corporation owns if the debt is corporate debt).  The insolvency exclusion will be the amount of canceled debt that exceeds the fair market value of your assets. 

Did your debt arise from farming? 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. In addition to this, 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. 

Is real property involved? Qualified Real Property Business Indebtedness (“QRPBI”) generally means pre-1993 debt of a C corporation collateralized by real estate used in a business; or, if after 1993, the debt was Qualified Acquisition Indebtedness used to acquire, construct, reconstruct, or substantially improve such real estate and taxpayer elects to treat that acquisition debt as QRPBI.  

Is the debt related to your home? An exception exists if the debt is tied to the taxpayer’s principal residence. Up to $2 million of canceled debt may be excluded for those married filing jointly ($1 million for single taxpayers). For such exception to apply, the debt must have been discharged before January 1, 2017.

Are you a student? Student loan COD may be excluded in certain cases where the student works for a certain period of time in certain professions for a broad class of qualifying employers.

One lesser known exception:

Did you receive a gift or inheritance? This type of debt cancellation exclusion would be considered reasonable by IRS if the original debt was between related parties, i.e., family members, but not if by a bank or employer with whom you have a strictly business or working relationship.

In most instances, once COD is excluded from income, you are required to reduce other tax “attributes” (other items you have that may otherwise provide deductions and credits) -  this serves as a form of penalty for the COD exclusion. 

Does your head hurt from reading this article? No exception here! Canceled debt, its tax consequences, and the possible exceptions that could arise can be confusing for anyone. If you have a debt that may soon be canceled or have questions about an already forgiven debt, please email me or contact a member of our Tax Consulting team today. We look forward to advising you on this and any other tax issue you may have.

About the Author | John Mascaro, CPA

John is adept in helping companies develop and execute complex domestic and international tax strategies. He has served some of the world’s largest companies in varied industries, including IBM, Schlumberger, Siemens; and later specialized in the entertainment and media industry serving such notables as Viacom, Blockbuster Entertainment, MTV, VH1, Nickelodeon, SONY Pictures, SONY Music, Newsweek Magazine, McCann Erickson Advertising, Gruner & Jahr Publishing, Reuters and numerous entertainment and media celebrities.

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