Review of the Rules
(Exceptions and Exclusions)
In general, taxable income includes all income from debt cancellation. This applies equally to debts discharged by commercial lenders and those canceled by private lenders. However, there are several exceptions to the general rule. In addition, there are numerous exclusions for certain types of forgiven debts.
Form 1099-C, Cancellation of Debt. A taxpayer should receive a Form 1099-C from a federal government agency, financial institution, or credit union that forgives a debt of $600 or more. The amount of the canceled debt is shown in box 2. Any forgiven interest included in the amount of canceled debt in box 2 will also be shown in box 3. As noted above, if the interest would otherwise be deductible, it does not have to be included in income.
An individual who doesn't agree with the amount shown on Form 1099-C should contact the lender in writing and request it to issue a corrected Form 1099-C showing the proper amount of canceled debt. Even if the lender refuses to issue a corrected report, there still may be recourse if the taxpayer has adequate documentation to show that the lender incorrectly reported the amount canceled.
For example, in a recent case, a $2,875 debt was no longer collectible because the period of limitations on a suit to collect had expired. Even so, the borrower offered to pay $1,000 as the amount "actually owed." The lender accepted and sent a 1099-C showing debt cancellation income of $1,875. The Tax Court found that the borrower had an uncontested and liquidated outstanding balance of $1,000. Because he paid $1,000 to settle the account, he had no debt cancellation income.
Gift exception. If a debt cancelled by a private lender, such as a relative or friend, is intended as a gift, there is no income. Likewise, a debt cancelled by a private lender's Last Will and Testament triggers no income to the borrower.
Student loan exception. In the case of an individual, gross income does not include any amount if the discharge was made under a provision of the loan that the indebtedness would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of employers.
For example, doctors, nurses, and teachers agreeing to serve in rural or low income areas in exchange for cancellation of their student loans will not have income from the cancellation if they meet certain conditions.
Exception for deductible debt. There is no income from cancellation of deductible debt. For example, if a lender cancels home mortgage interest that could have been claimed as an itemized deduction on Schedule A of Form 1040, there is no income.
Price adjustment. There is no income if an individual purchases property and the seller later reduces the price. The purchaser's basis in the property, however, is reduced by the amount of the purchase price adjustment.
Discharge of debt through bankruptcy. No amount is included in a debtor's gross income by reason of a discharge of indebtedness in a Title 11 (bankruptcy) case, but only if the taxpayer is under the jurisdiction of the court in such a case and the discharge is granted by the court or in a court-approved plan. The amount of discharged debt that is excluded from the debtor’s gross income must be applied to reduce certain of his tax attributes unless he elects to reduce his basis in depreciable assets or in real property held as inventory.
Discharge of debt of an insolvent taxpayer. A debtor may be insolvent (although not in bankruptcy) when his indebtedness is discharged. In this case, the amount of debt discharge is excluded from the debtor's gross income, up to the amount of his insolvency. The amount excluded under this insolvency exception is applied to reduce the debtor's tax attributes in a specified manner. Alternatively, the insolvent debtor may elect to reduce his basis in depreciable assets or in real property held as inventory.
Discharge of qualified farm debt. The discharge of qualified farm indebtedness by a qualified person outside of bankruptcy does not generate cancellation of debt income to a solvent taxpayer. This qualified farm indebtedness exclusion is applied after the insolvency and Title 11 (bankruptcy) exclusions. Thus, it does not apply to the extent the debtor is insolvent or to a debtor in Chapter 11, bankruptcy. The excluded amount of discharged qualified farm indebtedness can't exceed the sum of the taxpayer's adjusted tax attributes plus the aggregate adjusted bases of qualified property he holds at the beginning of the tax year j following the tax year in which the discharge occurs.
Discharge of qualified real property business debt. A discharge of qualified real property business indebtedness of a solvent taxpayer other than a C corporation outside of bankruptcy does not result in cancellation of debt income (subject to a limit). The amount excluded from gross income is applied to reduce the basis of the taxpayer's depreciable real property.
Discharge of qualified principal residence debt. Any discharge of indebtedness income by reason of a discharge (in whole or in part) of qualified principal residence indebtedness (below) is excluded from the taxpayer's gross income. This exclusion applies where a taxpayer restructures his acquisition debt on a principal residence, loses his principal residence in a foreclosure, or sells a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance). The taxpayer's basis in the residence must be reduced. "Qualified principal residence indebtedness" is acquisition indebtedness on the taxpayer's principal residence, up to a $2 million limit ($1 million for married individuals filing separately).
Deferral of cancellation of debt income on the repurchase of debt at a discount. For debt discharges in tax years ending after Dec. 31, 2008, a taxpayer can elect to have debt discharge income from the reacquisition of an applicable debt instrument after Dec. 31, 2008, and before Jan. 1, 2011, included in gross income ratably over five tax years beginning with:
(1) for repurchases occurring in 2009, the fifth tax year following the tax year in which the repurchase occurs, and
(2) for repurchases occurring in 2010, the fourth tax year following the tax year in which the repurchase occurs.
Observation: Although all of the deferred debt discharge income will eventually be recognized, the taxpayer benefits from the deferral of tax to later years. In addition, none of the taxpayer's tax attributes have to be reduced.
An applicable debt instrument means any debt instrument that was issued by a C corporation, or any other person in connection with the conduct of a trade or business by such person. Debt instrument is broadly defined to include a bond, debenture, note, certificate, or any other instrument or other contractual arrangement constituting indebtedness.