Tax Consequences of Debt Cancellation to the Borrower
Posted 3-10-2010
In this economy, many financially distressed borrowers may have had some or all of their debts cancelled or forgiven by a lender in 2009. While relief was welcomed by those who received it, there may be tax consequences. Debt forgiveness may need to be reported as income on the debtor's 2009 tax return unless one of the following exceptions or exclusions highlighted below applies.
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. There is an exception for certain student loans. For example, doctors, nurses, and teachers agreeing to serve in rural or low income areas in exchange for cancellation of their student loans won't 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. However, the purchaser's basis in the property 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.
Discharge of debt of an insolvent taxpayer. A debtor may be insolvent (although not in bankruptcy) when his/her indebtedness is discharged. In this case, the amount of debt discharge is excluded from the debtor's gross income, up to the amount of insolvency.
Discharge of qualified farm debt. The discharge of qualified farm indebtedness by a qualified person outside of bankruptcy doesn't 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 doesn't apply to the extent the debtor is insolvent or to a debtor in Chapter 11 bankruptcy.
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 doesn't 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 is excluded from the taxpayer's gross income. This exclusion applies where a taxpayer restructures acquisition debt on a 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). 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).
Repurchased business debt. Income from certain repurchased business debt can be stretched out over several years. Although all of the deferred debt discharge income will eventually be recognized, there is some benefit from the deferral of tax to later years.
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 also will be shown in box 3. 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 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.
If you had debt forgiven in 2009, please contact Gloria McDonnell, CPA, gmcdonnell@hlbtr.com, or Sue Weiskopf-Larson, MBT, CPA, sweiskopf@hlbtr.com to help determine the effect on your 2009 taxes.