Debt Forgiveness of Tax-Deductible Items
When a taxpayer is forgiven debt owed on a tax-deductible item, questions may arise about whether the amount needs to be included in cancelation of debt (COD) income.
Discharge of a liability that would have given rise to a deduction by the debtor doesn't result in debt cancellation income. (Code Sec. 108(e)(2)) Typically this is encountered when the lender includes unpaid interest with the principal amount of debt canceled on the 1099-C. The key here is to remember that to be excluded from COD income the interest would have had to be deductible had the taxpayer paid it.
Example – Credit Card Debt Cancelation – Rob had credit card consumer debt cancelled. In Box 2 of the 1099-C was an amount of $10,000 and in Box 3 an amount of $1,000. The $1,000 represents unpaid consumer interest which is not deductible, so the COD income is $10,000 which includes the $1,000 interest. However, if the card had been used exclusively for Rob’s Schedule C business, the COD income would only be $9,000 ($10,000 - $1,000) since the interest would have been deductible as a business expense.
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Example – Home Mortgage Debt Cancellation – Mike lost his home to foreclosure in 2017. He had refinanced the home’s original purchase money debt of $270,000 and at the time of the foreclosure the debt was $500,000. None of the extra debt was used for substantial home improvements nor can any excess debt be traced to other deductible purposes. Mike’s original loan would have been $250,000 at the time of the foreclosure. The amount in Box 2 of the 1099-C is $200,000 and Box 3 includes an amount of $55,000. Thus, the amount in Box 3 must be prorated between deductible and non-deductible interest. Mike can deduct the interest for acquisition debt and $100,000 of equity debt. Thus the amount of the interest that would have been deductible is $38,500 (((250,000 +100,000)/$500,000) x $55,000). As a result Mike’s COD income is reduced to $161,500 ($200,000 - $38,500). If the foreclosure had occurred after 2017 but before 2026 when equity debt interest isn’t deductible, only the acquisition debt portion of the interest will be deductible, and the COD income will be reduced to $172,500 ($200,000 – (250,000/500,000 x $55,000)).
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Example – Business Debt - Suppose you are the accountant for a small cash basis business. The business falls on hard times and cannot meet all of its liabilities. You decide to forgive a portion of the amount the business owes you. The forgiven amount becomes debt relief income to the business but is excluded from that company’s income because it would have been deductible if paid.
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Gift Exception for Loan Cancellation
When debt cancelation is intended as a gift, the IRS provides taxpayers with a gift exception option on their federal income taxes.
If a debt canceled 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. (IRC Sec. 102)