Written by Glen R Allie, CPA and Partner at Del Principe and Allie
The tax treatment of debt cancellation will vary depending on your situation. The cancellation of debt may result in ordinary income, income from the sale of assets, or both. However, there are exceptions and exclusion from the possibility that income will be included that are discussed below.
The situations that can cause income inclusion of cancelled debt are as follows:
- A debt owed by an individual that is cancelled or forgiven generally results in that amount being taxed as ordinary income from the cancellation of debt.
- Property that is secured for a debt that is taken by a lender in full or partial satisfaction of that debt is treated as a sale of the property which may result in a gain or loss.
- Recourse debt is a debt that is not backed by the collateral of the borrower. This type of debt allows the lender to collect, from the debtor and the debtor’s assets in the case of default. Nonpayment of recourse debt allows the lender the right to collect assets or pursue legal action. Property that is secured by this debt that is taken by the lender and the lender cancels this recourse debt, in excess of the fair market value of the property taken, is treated as excess cancellation of debt of the fair market value and is treated as ordinary income from cancellation of debt. This amount is included as income and is includable in addition to any gain or loss from the sale of that property taken by the lender.
- Situations that do not cause the inclusion of income would be the cancelled debt that is intended as a gift.
Cancellation of Non-Business Debt
Examples of the cancellation of non-business debt include, but are not limited to, discounts and loan modifications, main home foreclosure or abandonment and main home loan modification.
Discounts and loan modifications are when a lender “discounts” or reduces the principle balance of a loan to reward early payoff, or agrees to a loan modification that includes a reduction in the principle balance, the amount of the “discount” or principle reduction is cancelled debt. If the debt is nonrecourse and the individual did not retain the collateral, there is no cancellation of debt income. Nonrecourse debt is a secured loan that is secured by the pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender can seize the collateral, but the lender’s recovery is limited to the collateral. However, if the individual is personally liable for the loan, then the cancellation of debt is income, unless an exception or exclusion applies. These exceptions and exclusions are discussed below.
If a lender forecloses on a main home or the loan was abandoned the amount to include in income or the non-deductible loss on the foreclosure is calculated. The foreclosure or the repossession is treated as a sale from which the individual may realize a gain or loss. In addition, if the outstanding loan balance is more than the fair market value of the property, and the lender cancels all or part of the remaining debt, the individual may also realize income from the cancellation of debt unless the exceptions explained below apply.
Gain or loss from a foreclosure is figured and reported the same way as gain or loss from a sale. The selling price used to compute the gain or loss depends on whether the individual is personally liable for repaying the debt. Remember that the gain or loss from foreclosure of a principle residence can be excluded from income if the tests for exclusion are met. These exclusions are explained fully in Internal Revenue Publication 4681 “Canceled Debts, Foreclosures, Repossessions and Abandonments”. The publication can be found at www.irs.gov/pub/irs-pdf/p4681.pdf . This twenty six page publication is a great education tool providing worksheets, illustration of forms and examples to help understand this complicated area.
Personal Losses from Foreclosures and Repossessions
Remember too that personal losses from foreclosures and repossessions are not deductible.
As explained above, if a loan is a recourse loan, the individual must generally report two transactions on their tax returns:
- Cancellation of debt income
- Gain or loss on the sale
Bankruptcy, insolvency, and other exceptions (see below) that apply to the cancellation of debt income do not apply to the exclude gains from income.
As explained above, if a loan is a non-recourse loan, a foreclosure or repossession will be treated as a sale (which may result in a gain or loss), but there will be no cancellation of debt income
Exceptions to the Inclusion of Cancelled Debt
Several exceptions to the inclusion of cancelled debt income are:
- Gifts and bequests
- Bankruptcy: Debt cancelled in a bankruptcy case under Title 11 of the US Code
- Insolvency: Do not include cancelled debt in income to the extent that the individual was insolvent immediately prior to the cancellation
- Qualified principle residence indebtedness
1099-A and 1099-C
Finally, a creditor is required to issue a 1099-A “Acquisition or Abandonment of Secured Property” when a borrower abandons real or personal property. The Form 1099-A reports the information needed to determine the amount of gain or loss and any ordinary income from cancellation of debt that is not a discharge of qualified personal residence indebtedness. According to the IRS 1099-A instructions, “An abandonment occurs when the objective facts and circumstances indicate that the borrower intended to and has permanently discarded the property from use.”A 1099-A is not a notice of forgiveness.
If the financial institution issues a 1099-C to you, then it has forgiven the debt and you must report the amount on the 1099-C as income. IRS Publication 4681 “Canceled Debts, Foreclosures, Repossessions, and Abandonments “ (for individuals) provides excellent guidance to determine if you meet income exemptions or exclusions. Topics include exceptions to inclusion of canceled debt from gross income and canceled debt that can be excluded from gross income. This publication is available on-line by searching www.irs.gov.
Glen R Allie CPA is a partner at Del Principe and Allie CPAs PC; he has been a practicing CPA for over 33 years. Del Principe and Allie specializes in financial, estate, tax planning and preparation along with professional consulting services for a wide range of clientele including professional service, retail and manufacturing businesses.
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