Taxation of Canceled Debt
A debt that is canceled by the lender because it cannot collect the debt, such as in a foreclosure or a short sale, or because the statute of limitations prevents the collection of the debt, is considered taxable ordinary income – otherwise known as cancellation of debt, or COD, income unless:
- the debt was discharged in bankruptcy;
- the debt was less than $600;
- the debtor is insolvent, with debts greater than assets, but only to the extent of the insolvency, meaning that the amount of debt equal to assets will still be considered COD income;
- Example: The bank cancels $100,000 of your debt, but you own a $10,000 car free and clear; therefore, $10,000 is still considered taxable COD income; the remaining $90,000 is considered nontaxable income because of your insolvency.
- the canceled debt was a gift or an inheritance from a friend or relative; however, there is an irrebuttable presumption that debt canceled by a commercial lender is not a gift;
- or, if a secured debt is canceled by the repossession of the security, and if the fair market value (FMV) of the foreclosed or repossessed property is greater than the canceled debt, then the debt would be paid by its sale. If the canceled debt is greater than the FMV of the security, then:
COD Income = Canceled Debt Amount - FMV
There may also be a tax on capital gains on the forced sale of property securing a debt.
In the year of the discharge or of the cancelation of debt, the debtor can file a tax return using the usual rules, but in the next year, certain losses, credits, and the adjusted basis of property — collectively known, in this context, as tax attributes — that the debtor could have claimed at the start of bankruptcy must be reduced by the amount of the canceled debt, either dollar for dollar or 1/3 of each dollar of discharged debt. As each dollar of discharged debt is applied to reducing either the adjusted basis of property or reducing the tax attributes, the remaining applicable discharged debt is reduced. (IRC §108(b)) See Tax Attributes for more information.
Although it may seem harsh to tax canceled debt when the borrower is down on his luck, these rules are necessary to prevent abuses, where, for instance, phony loans may be used as a payment for services by solvent borrowers.
Qualified Principal Residence Indebtedness
There is a temporary exclusion from taxable income, applicable for the 2007-2016 tax years, of qualified principal residence indebtedness, which is a debt that:
- was used to acquire, construct, or substantially improve a qualified principal residence;
- is secured by the principal residence; and
- was less than a total of $2 million, or $1 million if filing separately, of such debt that was forgiven from 2007 to 2016. (This tax break has been extended twice.)
The reduction in debt by the lender must have been because of the declining value of the home or because of the deteriorating financial condition of the borrower, not because the borrower performed services for the lender in exchange for a reduction of the loan principal. If the indebtedness was canceled through bankruptcy, then the bankruptcy homestead exclusion must be applied rather than the exclusion for the qualified principal residence.
Refinanced debt also qualifies but only to the extent that the debt was used to acquire, construct, or substantially improve the principal residence. The $2 million exclusion applies to all canceled debts that occurred from 2007 to 2016 and is claimed on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. If the taxpayer continues to live in the residence, then the basis of the property must be reduced by the amount of the forgiven debt. If only part of the debt is qualified, then the exclusion only applies to that portion of the debt.
Example 1 — Qualified Principal Residence Indebtedness
If a taxpayer had a home that was sold for $600,000, which had a debt of $900,000, of which only $700,000 was qualified principal residence debt, because the taxpayer used the other $200,000 to pay off credit card debt, and the lender accepted the $600,000 as full payment of the loan, thereby forgiving $300,000 of the debt, then:
Qualified Excluded Debt = $300,000 – ($900,000 – $700,000) = $300,000 – $200,000 = $100,000
Taxable COD Income = $200,000
However, the $200,000 may be excludable under the insolvency rules, discussed later.
Foreclosures, Short Sales, and Repossessions
With the recent decline of home prices, many homes are worth less than the amount of money owed on the property, especially for borrowers who took advantage of lax lending standards, and bought with no money down or used inflated home appraisals. Consequently, many homeowners whose homes were foreclosed by the lender may owe significant taxes. The IRS treats all forgiven debt as ordinary income, unless an exclusion applies, such as the qualified principal residence indebtedness discussed above, even though in the case of foreclosure, the homeowner doesn't get to keep the home.
If the home was the borrower's main residence, then there may be no capital gains tax due because of the home sale exclusion that exempts gains of $250,000 for a single taxpayer, or $500,000 for a married couple filing jointly, on a main residence where the taxpayer lived for at least 2 years out of the 5 years before the sale. IRC §121
Because the lender has some discretion in valuing a home, it can sometimes be successfully argued that the fair market value of the home was greater than the debt, in which case, no COD income tax would be due. Although a higher FMV may increase the capital gain on the home, the long-term capital gain tax is usually much less than the tax on ordinary income.
Whenever a canceled debt involves real estate, the amount of COD and taxable income will depend on several factors:
- whether the debt was a recourse or nonrecourse loan,
- the fair market value of the real estate,
- the borrower's tax basis in the property,
- the sale price of the property,
- whether there were unpaid property liabilities, such as real estate taxes.
If any due taxes are not paid for the year the debt was canceled, then the IRS adds penalties and interest to the total tax bill, which can often be tens of thousands of dollars. (See After Foreclosure, a Big Tax Bill From the I.R.S.)
When a lender forecloses on a home, or if the home is sold in a short sale, or if another type of secured property is repossessed, the IRS treats it as a sale. A nonrecourse loan is secured by collateral and only the collateral can be used to satisfy the debt in case of default. So the lender of a nonrecourse loan can repossess the collateral but has no recourse to the borrower for any deficiency – hence, the name. Any deficiency of a nonrecourse loan is, therefore, not considered COD income because the borrower has no liability for it, so there is no legal effect of having it forgiven. The lender has, in effect, bought the property from the borrower for the amount of the debt, so that amount that is above the borrower's adjusted basis is treated as a capital gain. However, a capital loss from a foreclosure or repossession of personal property cannot be deducted.
Capital Gain = Canceled Debt of Nonrecourse loan – Adjusted Basis of Property
Example 2 – Calculating Capital Gain on a Canceled Nonrecourse Loan
- Outstanding Nonrecourse Loan Amount = $200,000
- Adjusted Basis = $120,000
- Capital Gain = $200,000 - $120,000 = $80,000
- Ordinary Gain = 0
The borrower is personally liable for the debt of a recourse loan, so, if the loan is forgiven after repossession, then the borrower realizes income on the foreclosed or repossessed property equal to the smaller of the canceled debt of the recourse loan or the fair market value of the property.
Canceled Debt of Recourse Loan = Outstanding Debt before Repossession – Amount of Debt for which the Borrower is still liable after the Repossession
Realized Income from Foreclosure = Smaller of (FMV or Canceled Debt of Recourse Loan) + Any Proceeds from Foreclosure Sale
Why the smaller of FMV or the canceled debt rather than the greater of either quantity? Because if the canceled debt is greater than the FMV, then the difference is treated as ordinary income; if FMV is greater, then that amount is subject to a capital gain rate rather than the ordinary rate — since the lender receive full value for the debt, there is no canceled debt and, therefore, no COD income. So, for a recourse loan, there may be both ordinary income and capital gains taxes to be paid. Income taxes must be paid on the difference between the COD income and the FMV of the property. If the canceled debt is greater than the FMV, then the difference is ordinary income:
If Canceled Debt > FMV, then
Ordinary Income = Canceled Debt on Recourse Loan - FMV
If the fair market value is greater than the adjusted basis of the property, then there will also be a taxable capital gain. Any canceled debt up to the FMV of the property is not considered ordinary income because the lender can recoup the amount by selling the property, so the borrower is considered to have paid that part of the debt by relinquishing the property. However, if the FMV is greater than the borrower's adjusted basis in the property, then the difference is taxed as a capital gain:
If FMV > Adjusted Basis of Property, then
Capital Gain = FMV - Adjusted Basis of Property
Example 3 — Recourse Debt in which both a Capital Gain and COD Income Results from the Foreclosure.
If the outstanding amount of the recourse debt is $200,000, the FMV of the property is $170,000, and the adjusted basis is $120,000, then:
- COD Income = $200,000 - $170,000 = $30,000
- Capital Gain = $170,000 - $120,000. = $50,000
Example 4: Calculating COD Income for Recourse and Nonrecourse Loans
A taxpayer buys a car, which is subsequently repossessed for nonpayment. Given the facts for each case below, calculate taxable income.
|Case #1 - Recourse Loan|
|Recourse Loan Amount||$16,000|
|Adjusted Basis on Repossession||$18,000|
|Loan Balance when Repossessed||$14,000|
|Recognized Income = Lesser of (Canceled Debt or FMV) =||$11,000|
|Recognized Income = Amount Forgiven = Loan Balance – FMV =||$3,000||Taxable COD income, unless an exception applies.|
|Amount Realized on Repossession = FMV =||$11,000|
|Capital Gain or Loss = Amount Realized – Adjusted Basis =||-$7,000||Non-Deductible Personal Loss|
|Case #2 - Same as Above, but Loan is Nonrecourse|
|Nonrecourse Loan Amount||$16,000|
|Adjusted Basis on Repossession||$18,000|
|Total Outstanding Debt before Repossession =||$14,000|
|Capital Gain or Loss = Total Outstanding Debt – Adjusted Basis =||-$4,000||Non-Deductible Personal Loss|
Unpaid property liabilities, such as property taxes, for the year in which the sale or foreclosure takes place are added to the canceled debt since the lender will be liable for those costs, unless the borrower ultimately pays them. The lender is required to send a Form 1099-C, Cancellation of Debt (COD) to the borrower, listing the amount of ordinary income. The lender will also send a Form 1099-A, Acquisition or Abandonment of Secured Property, that will allow the borrower to determine the capital gain or loss from the foreclosure.
Ordinary Income = Canceled Debt + Unpaid Property Liabilities - FMV
Example 5 – How Property Liabilities Affect Taxable Income
- Debt Amount = $200,000
- Fair Market Value = $170,000
- Unpaid Property Taxes = $10,000
- COD Income = Debt Amount – FMV + Unpaid Property Taxes = $200,000 – $170,000 + $10,000 = $40,000
However, if the property taxes are paid by the borrower, then:
- COD Income = Debt Amount – FMV = $200,000 – $170,000 = $30,000
The cancellation of student loans is generally considered taxable income. However, there are several exceptions if the student worked in a qualified public service:
- the lender is a government agency, a government-funded loan program of an educational institution, or a qualified hospital organization and the cancellation was the result of the taxpayer working in public service jobs at a reduced rate of pay;
- the debt was forgiven under the Loan Repayment Assistance program because the borrower worked in providing public service in government or tax-exempt charitable organizations.
The 2010 healthcare reform law also allowed loans to be forgiven for healthcare professionals if they worked for a minimum amount of time in underserved areas. The debt forgiveness for healthcare professionals is retroactive to 2009, so any students qualifying for the debt forgiveness can file an amended return.
There is also an insolvency exception for canceled debt. If a debt is canceled for an insolvent debtor outside of bankruptcy, then COD income can be excluded to the extent of the insolvency, which is equal to the total liabilities of the debtor minus the fair market value of his assets:
Excluded COD Income due to Insolvency = Total Liabilities – Fair Market Value of Assets
However, in calculating insolvency, the taxpayer must also include exempt assets, which are assets that are excludable both under state law from levy by creditors or from liquidation under bankruptcy. An insolvent taxpayer must also file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to reduce the same tax attributes that must be reduced under bankruptcy. Any remaining debt after the application of the insolvency exclusion that remains is taxable income.
So if a debtor has $10,000 of liabilities but only $4,000 of assets, then $10,000 – $4,000 = $6,000 can be excluded from taxable COD income by applying the insolvency exception.
If the debtor is a partnership, then the discharge of debt under bankruptcy, insolvency, or the cancellation of the debt must be allocated for each partner, and the above rules must be applied to each partner. However, the consequences of the debt discharge of an S corporation are determined at the corporate level – it is not passed through to the shareholders nor does it increase their basis.
If the debtor is solvent, but a seller of property reduces the purchase price of the property, then it is considered a price adjustment — not a cancellation of debt. The price reduction does, however, reduce the debtor's basis in the property. However, this rule only applies to solvent taxpayers and for property that has not been transferred to any 3rd party nor has the seller transferred the debt to a third-party, such as a collection agency.
Qualified farm debt of a solvent farmer may also be excluded from taxable income if the debt was forgiven by an unrelated lender, where the loan was used for operating a qualified farm business, where at least 50% of the gross receipts of the preceding 3 taxable years was derived from farming. The excluded debt 1st reduces tax attributes, then it reduces the basis in property that is not farmland, and then it is applied to the basis of the farmland.
|Part 1: Liabilities|
|Credit card debt||$45,000|
|Mortgages, home equity loans, investment and business loans||$300,000|
|Car and other vehicle loans||$15,000|
|Medical bills owed||$25,000|
|Outstanding debt: mortgage interest||$26,000|
|Outstanding debt: real estate taxes|
|Outstanding debt: utilities (water, gas, electric)|
|Outstanding debt: child care costs|
|Outstanding debt: prior -year federal or state income taxes|
|Margin debt on securities|
|Other liabilities not already included|
|Total Liabilities =||$521,000|
|Part 2: Fair Market Value (FMV) of Assets|
|Cash and bank account balances||$6,000|
|All real estate owned by the debtor||$290,000|
|Cars and other vehicles||$23,000|
|Household goods and furnishings||$10,000|
|Stocks, bonds, and other financial instruments|
|Coins, stamps, paintings, or other collectibles|
|Firearms, sports, photographic, and other hobby equipment|
|Interest in a pension plan|
|Interest in education accounts|
|Cash value of life insurance|
|Security deposits with landlords, utilities, and others|
|Interests in partnerships|
|Value of investment in a business|
|Other investments (annuity contracts, mutual funds, commodities, hedge funds, options, etc.)|
|Other assets not already included|
|Total Assets =||$342,010|
|Part 3: Total Insolvency|
|Insolvency = Total Assets – Total Liabilities = $342,010 – $521,000 =||-$178,990|
An abandonment occurs when the owner of a property voluntarily disclaims ownership of the property without naming a successive owner, in which case, ownership reverts to a prior owner or one who has a secured interest in the property or to the state if there are no successors. If business or investment real estate is abandoned, then the owner can claim an ordinary loss equal to the amount of the property's adjusted basis on Form 4797, Sales of Business Property. If the property is later repossessed or foreclosed, then any gain or loss will be subject to the rules for foreclosures or voluntary conveyances.
Qualified Business Real Estate Debt Forgiveness Exclusion
A solvent taxpayer may exclude the discharge of qualifying real property business debt if the debt was incurred in connection with the business and the loan was secured by such property. An insolvent taxpayer must claim the insolvency exclusion before claiming the qualifying business debt exclusion. The maximum amount that can be excluded equals the outstanding loan principal immediately before the discharge minus the fair market value of the real property, also immediately before the discharge, securing the debt minus any other qualifying real property business debts that are secured by the property. However, the exclusion amount may not exceed the taxpayer's adjusted basis for all of the depreciable real property that was held immediately before the discharge, since the basis of the property must be reduced by the amount of the excluded debt.
Excludable Amount = Loan Principal — FMV – Other Business Loans Secured by the Property
Excludable Amount ≤ Lesser of Adjusted Basis of All Depreciable Real Property or Loan Principal – FMV
Insolvency Exclusion Rule is Applied Before Calculating the Excludable Amount Under this Rule
Consequence: Adjusted Basis of All Real Property = Previous Basis – Excluded Amount
Any property with a reduced adjusted basis because of the cancellation of debt may later be subject to recaptured depreciation if the property is sold at a profit.
Example: Qualified Business Real Estate Debt Forgiveness Exclusion
You have a retail store.
- Adjusted Basis in Property = $145,000
- FMV of Property = $120,000
- Recourse Debt Secured by Property = $134,000
- Net Operating Loss (NOL) = $15,000
You run into financial difficulty, so the bank cancels some of your debt in a workout agreement:
- Maximum Debt That Can Be Excluded = Lesser of [(Debt Secured by Property – FMV of Property) or Adjusted Basis of all Real Property] = $134,000 – $120,000 = $14,000
- Canceled Debt under Workout Agreement = $13,000
- Extent of your Insolvency = $10,000
- Amount Excluded from COD Income Because of Insolvency = $10,000
- NOL Reduction Because of Insolvency Exclusion = NOL – Insolvency Exclusion = $15,000 – $10,000 = $5000
- Remaining Debt Canceled as Qualified Business Debt = $3000
So in this case, all of the $13,000 in debt forgiveness will not be counted as COD income, but the remaining NOL that can be used to offset current or future income will be reduced to $5,000, which will be reported on Form 982.
Tax Debt Relief by the IRS
Because of the recent credit crisis and the large number of taxpayers that became deeply indebted, the IRS has instituted the following rules to mitigate their problems:
- The number of liens filed by the IRS has increased from 168,000 in 1999 to 1.1 million in 2010, so the IRS is implementing the following changes concerning tax liens:
- The IRS will not file a property lien if the amount owed is less than $10,000, which is double the previous amount.
- When the debt is paid, then the IRS will grant the taxpayer a lien withdrawal, where the IRS will not only release the lien, but will also remove it from the credit reports of the taxpayer. Usually, a lien release stays on the credit report for 7 years, which can cause the credit score of the taxpayer to drop by up to 100 points for someone with an initially high score. The IRS may grant a lien withdrawal even if the taxpayer has not fully paid off the debt, if the amount is less than $25,000 and the taxpayer agreed to a direct debit from his bank account.
- For small businesses, the IRS will also offer streamlined installment agreements, allowing a business to pay off a tax debt of $25,000 or less over a period of 24 months if the taxpayer agrees to an automatic debit from his bank account. Previously, the IRS only allowed this if the debt was $10,000 or less.
- The IRS may also offer the taxpayer an offer in compromise, allowing the taxpayer to pay a lot less than what is owed, if the IRS is convinced that:
- the taxpayer will be unable to pay the full amount of the debt,
- the amount owed is less than $50,000, and
- the taxpayers income is less than $100,000.
The $50,000 and $100,000 limits are double the previous limits.