Generally, any debts canceled by bankruptcy or because of insolvency are not includable as income (IRC §108), so they are not subject to the cancellation-of-debt income rules. 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))
The taxpayer may elect, on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, which is the form used to reduce tax attributes, to reduce the basis of depreciable assets before reducing the other tax attributes. This election allows the taxpayer to keep current deductions which can be used to reduce taxable income in the following tax year. However, the reduction in basis will increase gain or decrease loss on the property if it is disposed of.
If the election is not made or there remains discharged debt that has not been applied to reductions, then tax attributes must be reduced in the following order:
- Net operating losses (NOLs) and carryovers, dollar for dollar.
- So if $10,000 of debt was discharged and the taxpayer had $6,000 of NOLs, then the NOLs are eliminated, so they cannot be used to reduce future taxes.
- Carryovers of the general business credit, 1/3 of each dollar.
- So if the above debtor also had $1,000 of general business carryovers, then this amount is eliminated by $3,000 of the canceled debt, leaving $1,000 for further reductions.
- Any alternative minimum tax credit that the taxpayer would have been able to claim for the tax year after the discharge, 1/3 of each dollar.
- Net capital losses and carryovers to the tax year of the discharge, dollar for dollar.
- The basis of property, dollar for dollar. Note that this option can be selected first, which will usually result in the greatest tax benefit.
- So, if the above debtor kept a home with an adjusted basis of $20,000, then the basis is reduced by the remaining un-apportioned discharged debt of $1,000 to $19,000. As already stated, the debtor could have chosen this option first, reducing the basis of his property by the full $10,000 of discharged debt to an adjusted basis of $10,000, thereby retaining the NOLs and the general business credit carryovers to reduce future taxes. Although the taxpayer would have an extra $10,000 of gain when he disposes of the property, the gain could probably be wholly excluded under the home exclusion rule.
- Passive activity losses, dollar for dollar and passive activity credits, 1/3 of each dollar, that could have been claimed in the discharge year.
- Foreign tax credit carryovers, 1/3 of each dollar.