Cancellation of Debt May Mean Tax Problems

In today’s world, as foreclosures, short sales and other forms of loan “workouts” seem to be ubiquitous, folks who may be under water might think their problems have only to do with getting the lender off their back.  But even if they are successful in doing same, they might have a nasty surprise come tax time if they hadn’t already considered how the Revenooers look at these sorts of events.

Debt cancellation or forgiveness is the general result of not paying 100% of a loan, and not having your lender come after you any further.  And in these situations, the debtor will generally have to recognize some form of taxable income unless some exception (of which the law provides several) may apply.  Look at it this way:  some time in the past, you pocketed some cash from a lender, and either used the dough to purchase an asset, or spent the money on some other personal or business necessity.  And when all is said and done, you don’t have to pay the lender back in full.  Result?  Income!

The common exceptions to this result are the following:

  1. Bankruptcy – No recognition of income from the discharge or cancellation of debt, generally speaking, which arises from a bankruptcy proceeding.
  2. Insolvency – No recognition of income if the debtor’s liabilities exceed the value of his assets – more on this later.
  3. Certain kinds of loans which the law refers to as “qualified farm debt.”
  4. Certain “qualified real property business indebtedness.”
  5. “Qualified principal residence indebtedness” for up to $2 million of acquisition debt incurred on the purchase of a principal residence.

As mentioned, insolvent taxpayers may find a way out of this potential mess.

Folks are “insolvent” when the fair market value of all of their assets is less than their debts.  And for this purpose, assets include everything, including pension plans and retirement accounts.  But certain “contingent” liabilities may also be included in the calculation if the taxpayer can prove that it is more probable than not that they may be called upon to pay these items.

A taxpayer’s insolvency is determined immediately before a debt discharge.

And if the cancelled debt is excluded from taxation by reason of bankruptcy, insolvency or the farm indebtedness rule, the taxpayer does have to give up something in return for Uncle Sam’s largesse in not lowering the tax boom – the taxpayer in these situations must reduce certain of his “tax attributes” up to the amount of debt excluded (thought not below zero).  In other words, in return for not paying tax now on the forgiven debt, taxpayers must give up their ability to use certain available future deductions or offsets, generally to include:

  1. Net operating loss carry forwards;
  2. Certain credit carryovers;
  3. Capital loss carryovers;
  4. Depreciable basis of certain property
  5. Passive activity loss and credit carryovers; and
  6. Foreign tax credit carryovers.

A complex area of the law indeed – if this is you, see a tax pro now!

CONSULT YOUR TAX ADVISOR – This article contains general information about various tax matters.  You should consult your CPA regarding the implications to your own particular situation.

Jeff Quinn, the author of this article, is a shareholder in Ashley Quinn, CPAs and Consultants, Ltd., with offices in Incline Village and Reno.  He may be reached at 831-7288, welcomes comments at jquinn@ashleyquinncpas.com, and invites readers to consider his other commentaries at at http://blog.nolo.com/taxes.

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