Types Of Cancelled Debt Excluded From Income
If a lender cancels part or all of a taxpayer’s debt, the amount of the debt cancelled is generally considered income that the taxpayer must pay tax on. However, tax law allows for exclusions that apply to taxpayers to the extent that they are insolvent, particularly to homeowners when the debt cancelled is home-acquisition debt for a primary residence. There is also a special exclusion for rental-property debt cancellation.
The following exclusions are available in 2016 in different circumstances:
- Loan Modification – If a lender cancels part of a taxpayer’s mortgage through a loan modification or workout, the taxpayer may be able to exclude the cancelled amount from taxable income using the debt-relief exclusions for insolvency and/or the acquisition of a principal residence. These exclusions may also apply to debt discharged as part of the Home Affordable Modification Program (HAMP).
- Real Estate Foreclosure, Abandonment or Short Sale – The debt-relief exclusions for insolvency and principal-residence acquisition may also apply to the amount of debt cancelled through foreclosure abandonment or the short sale of a taxpayer’s primary residence.
- Credit Card and Second Home Debt – If part of a taxpayer’s debt from a credit card or from second-home purchase is forgiven, only the insolvency exclusion applies.
- Repossession of a Car or Other Personal Property – Only the insolvency exclusion applies in these cases.
- Rental Property – Rental-property debt forgiveness can first be excluded under the insolvency exclusion; then – if any un-excluded debt remains – the exclusion for real-property business indebtedness can be used. However, this exclusion is limited to the basis in other property, which must be reduced by the amount excluded. Please call the office for further details.
The following definitions, which are used when excluding cancelled debt income, provide more details as to the tax ramifications:
Primary Residence – The taxpayer’s main home.
Acquisition Debt – Debt used to buy, build or substantially improve a taxpayer’s primary residence. Only acquisition debt can be applied to the temporary principal residence acquisition debt relief exclusion, which will expire after 2016. Refinanced debt continues to be acquisition debt to the extent that it replaces acquisition debt.
Insolvency – To the extent that a taxpayer’s debts exceed his or her assets, that person is insolvent. The determination of insolvency includes the forgiven debt, and in the case when an asset is used to secure the debt, the asset’s value is included in the taxpayer’s total assets.
Form 1099-C – The form that is received when a lender reduces or cancels at least $600 of debt. The form is titled “Cancellation of Debt,” and it shows the amount of cancelled debt along with other information.
Excluded Debt Reduces Tax Attributes – The excluded amount for the year is not necessarily forgiven. To the extent that a taxpayer has tax attributes (such as carryover losses/credits or basis in property), those attributes must be reduced by the amount of the debt relief.
Excluding cancellation-of-debt income can be quite complicated, and knowing the rules – including state-to-state differences – can be crucial in keeping yourself out of trouble with the IRS. Please call this office at 888-842-1366 for further guidance on your specific debt relief issue.