Debt Forgiveness or Cancellation of Indebtedness

Posted on April 5, 2010. Filed under: Tax Tips | Tags: , , |

Perhaps one of the most confusing matters encountered this tax year relates to the cancellation of indebtedness, or the impending cancellation of indebtedness regarding mortgage debt forgiveness.

Cancellation of indebtedness or “COD” in these cases is where the lender reduces or forgives the amount of debt owed, where it becomes apparent that the homeowner or investor is unable or unwilling to satisfy the debt obligation and the lending institution or bank believes it is in their best interests to cut their losses and run!

This is nothing new.  Lenders have always been subject to the risk where a buyer or investor would default on loan payments and the lender would have to take back the property and sell the property to satisfy the loan.

What is new is the market prices for properties has dropped or continues to drop so significantly that homeowners and investors have been forced to default on their loan payments and often “walk away” from their homes or investments in staggering numbers.

Tax Effects of This Transaction

When you, the homebuyer or investor, “walk away” from a property, or otherwise settle or renegotiate your debt for a lesser amount, the lender or bank will report a loss on your property.  Similarly, the lender or bank will issue you, the taxpayer, a Form 1099-C (Cancellation of Debt) for the amount that the debt has been reduced or forgiven.

Unless you meet one of the exceptions or exclusions, you are required to recognize ordinary income to the extent you have been relieved of the debt.  It does not matter that you never received the cash, that you didn’t make any money or receive benefits in any other way.  What matters is that you had a debt that was forgiven and the government wants you to pay the taxes associated with that debt.

Fortunately, there are exceptions to the general recognition of income available to you if you qualify as listed below.

1.  Home Mortgage Exception.

In 2007, in response to the mortgage crisis, Congress exempted up to $2 million (per couple) in mortgage debt on a principal home, forgiven from 2007 through 2012, from income (The Mortgage Debt Relief Act of 2007). This exemption applies if:

–You restructure “acquisition” debt on a principal residence–meaning debt you used to buy or improve a principal residence.

–You lose your principal residence in a foreclosure, or

–You sell your principal residence in a short sale, where the sales proceeds are less than you owe and the lender writes off the balance.

Not surprisingly, if your lender writes off a portion of your mortgage, you will have to reduce your basis in the residence by the amount of discharged debt not counted as income to you.

The relief provisions are applicable to your main or principal residence.  Debt relief for second homes, credit card or automobile loans do not apply here.

This special relief for forgiven mortgages isn’t automatic; you must file IRS Form 982, Reduction Of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) on a timely filed tax return.

2.  Bankruptcy discharges.

If your debt is discharged when you’re in bankruptcy, as part of a court-approved bankruptcy plan, it isn’t income to you. Since no income is recognized, the amount of the discharged debt will reduce other tax benefits, such as net operating losses or the basis of property. Once again, the rules are complicated and Form 982 is required.

3. The insolvency exception.

You can also get relief if you qualify under the “insolvency exception rules”. These provisions are perhaps the most beneficial relief provisions that apply to real estate investors.  Even if you are not in bankruptcy, if you are “insolvent” when your debt is discharged, there is no tax on the debt forgiveness. Insolvency is simply where your liabilities exceed the fair market value of your assets. To escape tax on the debt forgiveness, your liabilities must exceed your assets by more than the amount of the debt discharged.

Example:  Jeffrey owns assets with a fair market value of $500,000 and owes debts to various creditors totaling $625,000. Jeffrey, therefore, is insolvent by $125,000. Jeffrey pays one of his creditors $125,000 in agreed complete satisfaction of a $300,000 debt. The payment results in a discharge of indebtedness of $175,000, reduces the fair market value of Jeffrey’s assets to $375,000, and reduces the amount of his debts to $325,000. This arrangement, therefore, makes Jeffrey solvent by $50,000.  Jeffrey is considered to have $50,000 of income from the discharge of indebtedness. He has a $175,000 total discharge of indebtedness, but $125,000 is excluded from his income because Jeffrey was insolvent by this amount prior to the discharge of indebtedness

7. Cancellation of interest only.

There is generally no taxable income resulting from the cancellation of interest. If a lender cancels home mortgage interest (interest only, not the principal of the debt), and that interest could have been claimed as an itemized deduction on Schedule A to your Form 1040, there is no income.

8. You must account for Form 1099-Cs

Any lender, government agency, financial institution or credit union forgiving a debt of $600 or more has to issue a Form 1099-C to you and send one to the IRS too. If you receive this form and disagree with the amount shown, write the lender requesting that it issue a corrected Form 1099-C showing the proper amount of canceled debt. If you believe the canceled debt isn’t income to you because you’re insolvent or for any other reason, don’t ignore the 1099-C. Instead, fill out Form 982 explaining why it isn’t taxable.

9. Price adjustments by the seller.

There is no income if an individual purchases property and the seller later reduces the price of the property. Instead, the purchaser’s basis in the property is reduced by the amount of the adjustment. For example, let’s say you bought a rental property several years ago for $500,000, and you still owe the bank $400,000, and the unit is now worth only $350,000. The seller agrees to reduce the debt by $50,000. If this is just a debt discharge, its COD income subject to the same rules outlined above. However, if it is written as an adjustment to the purchase price, the reduction is not subject to additional taxation.

10. Delaying taxes on reacquiring debt.

Congress created yet another limited time rule allowing an individual or corporate taxpayer to delay the normal tax hit from reacquiring its own debt at a discount. The delay only applies if the debt was issued in connection with a trade or business and reacquired in 2009 or 2010. The debtor must include an election statement with the tax return in the year the debt is reacquired. Once made the election is irrevocable.  If you make this election, you cannot exclude the income from the COD based on a title 11 bankruptcy case, insolvency, qualified farm or real property business indebtedness.  Income is deferred until the 5 year after the reaquisition (4 year for reacquisitions in 2010), then included ratably over the following five year period.


These are just some of the many tax rules with regards to cancellation of indebtedness income. The tax rules outlined here include only the most general discussion of these most complex rules and are not intended to be fully representational. The rules and applicable reporting standards in the reporting of COD income or general tax planning guidance in anticipation of the debt cancellation are fairly complex and will require professional guidance from an experienced certified public accountant (CPA).

For additional information you can also refer to Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments (for individuals). Where this is all too confusing, call us!

We are a licensed certified public accounting (CPA) firm operating in .  We provide tax preparation and consulting services to both individuals and investors who have, or will have to deal with the reporting of COD income in the preparation of their individual or corporate income tax returns.

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