In the current economic climate, it is likely that practitioners are encountering more clients with debt discharge income than in the recent past. Often, the question that comes up is, is it taxable income and if it is taxable, how should it be reported? Taxpayers will sometimes receive a 1099-C (cancellation of debt) when they receive $600 or more of debt cancellation, whether or not the income is currently taxable. It is up to the tax preparer and taxpayer to determine the taxability of the income.
While 1099-C (PDF) is often required to be filed, not all entities are required to file them. The following entities are required to file 1099-C:
- Financial institutions.
- Credit unions.
- Federal Deposit Insurance Corporations (FDIC), Resolution Trust Corporations, National Credit Union Administration (NCUA), military departments, U.S. Postal Service (USPS) or any of their successors or sub-units.
- Corporations that are subsidiaries of financial institutions or credit unions, under certain conditions.
- Federal government agencies.
- Organizations in the trade or business of lending money.
In addition, entities are normally not required to file 1099-C for the following types of debt, types of debtor and debt cancellation situations:
- Bankruptcies, unless related to business or investment;
- Interest, but it may be reported;
- Non-principal amounts;
- Foreign debtors;
- Related party debtors;
- Debtor is released, but one or more debtors remain liable for the full amount of the debt;
- Guarantors or sureties; and
- Seller financing.
Exceptions and Exclusions to Including Debt Discharges As income
Section 108 provides a number of exclusions from taxable income for income debt discharges even if a taxpayer does receive a 1099-C.
Under Sec. 108(a), exclusions from income are provided for debt discharge related to:
- Bankruptcy cases
- Insolvency of taxpayer
- Qualified farm debt
- Qualified real property business indebtedness
- Certain qualified principal residence indebtedness
The current exclusions from income provided under Sec. 108(a) do not necessarily mean that the debt discharge income is not taxable indefinitely. In some cases, the income is deferred through a reduction of tax attributes discussed below.
Other exclusions in Sec. 108 include exclusions for income from debt discharge from:
- Certain student loans (Sec. 108(f));
- Debt that would have been deductible if paid (Sec. 108(e)(2));
- Reduction of debt on seller financed property (Sec. 108(e)(5)).
Some student loans are written with a stipulation that if the borrower works for a certain number of years in a specified profession, either a portion or the entire amount of the loan will not need to be repaid. Examples of these professions are teaching, pharmacy and nursing. These amounts of forgiven debt are not taxable income.
Debt That Would Have Been Deductible If Paid
A discharge of debt that would have resulted in a deduction for the taxpayer if the taxpayer had paid the debt is not includible in income. For example, if a cash basis taxpayer has accrued interest that a lender forgives, it is not included in income.
In cases of debt discharges outside of bankruptcy and where the debtor is not insolvent, a discharge of debt related to a purchase of seller-financed property that would otherwise be treated as debt discharge income is not included in income. Instead, the amount discharged is treated as a purchase price reduction on the property.
In the case of debt discharge in bankruptcy, there is no taxable income, but there is a reduction of tax attributes. However, the taxpayer cannot reduce the attributes below zero.
For the insolvency exclusion, a calculation needs to be made to determine whether the taxpayer is insolvent. Debt discharge income is not taxable to the extent the taxpayer is insolvent. Insolvency is the amount by which liabilities exceed the fair market value (FMV) of assets. The taxpayer must reduce tax attributes by the amount of the excluded income.
Qualified Farm Debt
If debt is qualified farm debt, a portion of the debt discharged is not recognized as income. There are three conditions that the taxpayer must meet to qualify for this exclusion:
- Debt was incurred in the trade or business of farming;
- At least 50 percent of taxpayer’s aggregate gross receipts for the three years before the year of discharge was attributable to trade or business of farming; and
- The lender is unrelated to the debtor and is in the business of lending, unless it is a governmental agency.
The exclusion amount is limited to the adjusted tax attributes of the taxpayer and the aggregate adjusted bases of any property used for a trade or business or the production of income held by the taxpayer as of the beginning of the tax year following the tax year in which the discharge occurs. Any discharge in excess of these items is taxable.
The taxpayer must reduce tax attributes by the amount of the excluded income. The taxpayer reduces tax attributes in the following order: first, the basis of depreciable property, then the basis of land used in the farming business and, finally, the basis of other business and income producing property.
Qualified Real Property Business Indebtedness
A taxpayer may elect exclude a discharge of qualified real property business debt from income. The exclusion does not apply to cancellation of debt in bankruptcy or to the extent the taxpayer is insolvent. The exclusion is available for debt that secures real property used in a trade or business besides farming. The taxpayer makes the election on Form 982 (PDF), which must be attached to a timely filed (including extensions) income tax return. The exclusion is limited to:
- The outstanding principal amount of the qualified real property business debt; over
- The FMV of the business real property securing the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property.
The amounts used in this calculation are the amounts immediately before the debt cancellation. In addition, the exclusion is subject to a second limit of the adjusted basis of all depreciable real property held by the taxpayer.
There is a special exclusion for principal residence debt of up to $2 million ($1 million for married taxpayers filing separately) for debt discharges occurring before January 1, 2013. This exclusion is applicable to:
- Restructuring of acquisition debt;
- Loss of principal residence in foreclosure; and
- Sale of residence in which proceeds don’t cover the mortgage balance, which is forgiven.
The exclusion does not apply to a vacation home or second residences. The taxpayer must reduce the basis of the property (but not below zero) by the amount of the debt excluded.
Tax Attributes (Bankruptcy and Insolvency Exclusions)
There is a specific order in which a taxpayer should reduce their tax attributes for the bankruptcy or insolvency exclusions: net operating losses (NOL), general business credit carryovers, minimum tax credits, capital losses, basis of property, passive-activity loss and credit carryovers and foreign tax credits. However, the taxpayer may make an election on Form 982 to reduce the basis in depreciable property first. If the taxpayer reduces the basis of depreciable property and sells the property at a gain, the amount of basis reduction is taxed as ordinary income to the extent of the gain. (CPA Insiderâ„¢ readers should note that this order does not apply to discharges of qualified farm indebtedness, discussed above.)
Precedence of Sec. 108(a) Exclusions
There is also an order of precedence for the exclusions. Bankruptcy takes precedence over the other four exclusions. The principal residence exclusion comes before the insolvency exclusion unless an election is made. The insolvency exclusion comes before farm debt and real property business indebtedness.
Re-acquisition of Applicable Debt Instrument
The American Recovery and Reinvestment Act of 2009 (ARRA) made some changes to debt discharge income recognition. Debt discharge from the reacquisition of an applicable debt instrument after Dec. 31, 2008 and before Jan. 1, 2011, is includible in gross income ratably over a period of five tax years. The taxpayer recognizes the income ratably over five years beginning in 2014.
Modification of Debt
Debt does not have to be completely discharged to represent debt discharge income. A significant modification of debt may constitute debt discharge income. Whether the modification is significant depends on the facts and circumstances and include the following changes:
- Obligation’s yield
- Timing of payments
- Security or obligor
- Nature of the debt instrument
- Accounting or financial covenants
The amount of debt-discharge income is the amount that the issue price of the principal of the old debt exceeds the new principal issue price. If the interest rate is below the applicable federal rate, interest needs to be imputed and the principal amount may change.
When a taxpayer is involved with debt discharge income, the question of whether the income is partly or fully taxable depends on the taxpayer’s situations and is subject to several possible exceptions and/or exclusions.
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Debbie Mitchell, CPA, MBA, MST, is a principal with Braver PC Accountants and Advisors.