Cancellation of Debt Income

IRS cancellation of debt income

Cancellation of debt results if a debt that the taxpayer is personally liable is discharged (“forgiven”, or written off as uncollectible).

Reporting

IRC § 6050P requires certain financial institutions and federal agencies that cancel a debt of $600 or more during any calendar year to file information return Form 1099-C with the IRS and provide a copy to the taxpayer whose debt was cancelled.

Inclusion in income

Internal Revenue Code (“IRC”) § 61(a)(12) provides that gross income includes “income from discharge of indebtedness” (i.e., the amount written off is taxable).

Code (“IRC”) § 61(a)(12) provides that gross income includes “income from discharge of indebtedness” (i.e., the amount written off is taxable).

Gain of loss

The taxpayer may also realize gain or loss on the disposition as well as COD income if the debt is written off as a result of a foreclosure, sale, or other disposition of property that secures the debt, i.e., if the the fair market value (“FMV”) exceeds taxpayer’s basis.

The TAS YouTube channel is available at www.youtube.com/TASNTA 4/15/11

IRS Tax Tip 2011-44 — Ten Facts for Mortgage Debt Forgivenes 3/3/11

If your mortgage debt is partly or entirely forgiven during tax years 2007 through 2012, you may be able to claim special tax relief and exclude the debt forgiven from your income. Here are 10 facts the IRS wants you to know about Mortgage Debt Forgiveness.

  1. Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.
  2. The limit is $1 million for a married person filing a separate return.
  3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.
  4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
  5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
  6. Proceeds of refinanced debt used for other purposes ? for example, to pay off credit card debt ? do not qualify for the exclusion.
  7. If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.
  8. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions ? such as insolvency ? may be applicable. IRS Form 982 provides more details about these provisions.
  9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.
  10. Examine the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.

For more information about the Mortgage Forgiveness Debt Relief Act of 2007, visit IRS.gov. A good resource is IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. Taxpayers may obtain a copy of this publication and Form 982 either by downloading them from IRS.gov or by calling 800-TAX-FORM (800-829-3676).

Exceptions to inclusion in income, IRC § 108

IRC § 108 excludes discharges of indebtedness from gross income if:

  • The discharge occurs in bankruptcy
  • The discharge occurs when the taxpayer is insolvent
  • The debt is “qualified farm indebtedness”
  • The debt is a student loan for which the exclusion provided by IRC § 108(f) applies

Insolvency Exception

A taxpayer is insolvent to the extent that the taxpayer’s liabilities immediately before the discharge exceed the fair market value of the taxpayer’s assets immediately before the discharge. The amount excludable under the insolvency exception is limited to the amount by which the taxpayer is insolvent (the amount by which cancelled debt exceeds the amount taxpayer’s net worth is negative is taxable).

The Mortgage Forgiveness Debt Relief Act of 2007

This Act generally allows taxpayers to exclude up to $2MM of ($1MM if married filing separately) of income from discharge of debt on their principal residence in calendar years 2007 through 2012. Debt reduced through mortgage restructuring and mortgage debt forgiven in connection with a foreclosure qualify for this relief. The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

The amount excluded reduces the taxpayer’s cost basis in the home.

information on http://www.IRS.gov

More details and detailed examples can also be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Questions and answers based on the law prior to the passage of the Mortgage Forgiveness Debt Relief Act of 2007 are available.

The IRS has a comprehensive new insolvency worksheet included in the newly revised edition of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), to determine whether and to what extent taxpayers are insolvent, and thus whether and to what extent their canceled debts are excluded from gross income. http://www.irs.gov/pub/irs-pdf/p4681.pdf 4/27/09