If a debt is canceled or forgiven, other than as a gift or bequest, the debtor generally must include the canceled amount in gross income for tax purposes. A debt includes any indebtedness for which the debtor is liable or that attaches to property the debtor holds. In the event that the amount forgiven is $600 or more, the debtor should receive a Form 1099-C, Cancellation of Debt, from the lender. See Form 1099-C and the separate instructions. The debtor may not have to report the entire amount of canceled debt as income, as a variety of exceptions may apply. See Exceptions and Exclusions, next.taxmap/pubs/p908-005.htm#en_us_publink1000137391
The exceptions include:
- The cancellation of a student loan for a student required to work for certain employers. See Canceled Debts in Publication 525.
- The cancellation of debt that would have been deductible if paid. See Deductible Debt under Canceled Debts in chapter 5 of Publication 334.
- The reduction of a debt by the seller of property if the debt arose from the purchase of the property.
Do not include a canceled debt in gross income if any of the following situations apply:
- The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.
- The cancellation takes place when the debtor is insolvent (see Insolvency exclusion, later), and the amount excluded is not more than the amount by which the debtor is insolvent.
- The canceled debt is qualified farm debt (debt incurred in operating a farm). See Cancellation of Debt in chapter 3 of Publication 225.
- The canceled debt is qualified real property business indebtedness (certain debt connected with business real property). See Publication 525.
- The canceled debt is qualified principal residence indebtedness (applies to debt canceled between January 1, 2007, and December 31, 2009). See IRC section 108(a)(1)(E).
If the cancellation of debt occurs in a title 11 bankruptcy case, the bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, qualified real property business indebtedness, or qualified principal residence indebtedness exclusions.
To the extent that the taxpayer is insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions. The principal residence exclusion takes precedence over the insolvency exclusion, unless otherwise elected. See IRC section 108(a)(2)(C).taxmap/pubs/p908-005.htm#en_us_publink1000137394
A bankruptcy case is a case under title 11 of the United States Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
None of the debt canceled in a bankruptcy case is included in the debtor's gross income in the year it was canceled. Instead, certain losses, credits, and basis of property must be reduced by the amount of excluded income (but not below zero). These losses, credits, and basis in property are called tax attributes and are discussed under Reduction of Tax Attributes, later. taxmap/pubs/p908-005.htm#en_us_publink1000137395
A debtor is insolvent when, and to the extent, the debtor's liabilities exceed the FMV of the assets. Determine the debtor's liabilities and the FMV of the assets immediately before the cancellation of the debtor's debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent.
Exclude from the debtor's gross income debt canceled when the debtor is insolvent, but only up to the amount by which the debtor is insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes. taxmap/pubs/p908-005.htm#en_us_publink1000137396
$4,000 of the Simpson Corporation's liabilities are canceled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation's liabilities totaled $21,000 and the FMV of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 − $17,500). The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.taxmap/pubs/p908-005.htm#en_us_publink1000137397
If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain "tax attributes." Tax attributes include the basis of certain assets and the losses and credits listed later. By reducing the tax attributes, the tax on the canceled debt is partially postponed instead of being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation.
If a separate bankruptcy estate was created, the trustee or debtor-in-possession must reduce the estate's attributes (but not below zero) by the canceled debt. See Individuals under chapter 7 or chapter 11, earlier.taxmap/pubs/p908-005.htm#en_us_publink1000137398
Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below. However, the debtor may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. This choice is discussed later. taxmap/pubs/p908-005.htm#en_us_publink1000137399
Reduce any NOL for the tax year in which the debt cancellation takes place, and any NOL carryover to that tax year. taxmap/pubs/p908-005.htm#en_us_publink1000137400
Reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit. taxmap/pubs/p908-005.htm#en_us_publink1000137401
Reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation. taxmap/pubs/p908-005.htm#en_us_publink1000137402
Reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year. taxmap/pubs/p908-005.htm#en_us_publink1000137403
Reduce the basis of the debtor's property as described under Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property. taxmap/pubs/p908-005.htm#en_us_publink1000137404
Reduce any passive activity loss or credit carryover from the tax year of the debt cancellation. taxmap/pubs/p908-005.htm#en_us_publink1000137405
Last, reduce any carryover, to or from the tax year of the debt cancellation, of an amount used to determine the foreign tax credit or the Puerto Rico and possession tax credit. taxmap/pubs/p908-005.htm#en_us_publink1000137406
Except for the credit carryovers, reduce the tax attributes listed earlier 1 dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 331/3 cents for each dollar of canceled debt that is excluded from income. taxmap/pubs/p908-005.htm#en_us_publink1000137407
Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing NOLs and capital losses, first reduce the loss for the tax year of the debt cancellation, and then any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. Make the reductions of credit carryovers in the order in which the carryovers are taken into account for the tax year of the debt cancellation. taxmap/pubs/p908-005.htm#en_us_publink1000137408
In an individual bankruptcy under chapter 7 or 11 of title 11, the required reduction of tax attributes must be made to the attributes of the bankruptcy estate, a separate taxable entity resulting from the filing of the case. Also, the trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes. See the discussion of Taxes and the Bankruptcy Estate, earlier. taxmap/pubs/p908-005.htm#en_us_publink1000137409
If any amount of the debt cancellation is used to reduce the basis of assets as discussed under Reduction of Tax Attributes, the following rules apply to the extent indicated. taxmap/pubs/p908-005.htm#en_us_publink1000137410
Reductions in basis due to debt cancellation are made at the beginning of the tax year following the cancellation. The reduction applies to property held at that time. See Regulations section 1.1017-1 for more information. taxmap/pubs/p908-005.htm#en_us_publink1000137411
The reduction in basis for canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later. taxmap/pubs/p908-005.htm#en_us_publink1000137412
If debt is canceled in a bankruptcy case under title 11 of the United States Code, do not reduce the basis in property that the debtor treats as exempt property under section 522 of title 11. taxmap/pubs/p908-005.htm#en_us_publink1000137413
The estate, in the case of an individual bankruptcy under chapter 7 or 11, may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.
Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. The debtor may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. The debtor must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, the debtor can only revoke it with IRS approval. However, if the debtor establishes reasonable cause, the debtor may make the choice with an amended return or claim for refund or credit. taxmap/pubs/p908-005.htm#en_us_publink1000137414
Make the election to reduce the basis of depreciable property before reducing other tax attributes, as well as the election to treat real property inventory as depreciable property, on Form 982.taxmap/pubs/p908-005.htm#en_us_publink1000137415
If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain corresponding to the basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of the basis reduction as a depreciation deduction and by treating any such basis-reduced property that is not already either IRC section 1245 or IRC section 1250 property as IRC section 1245 property. In the case of IRC section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation. IRC sections 1245 and 1250 and the recapture of gain as ordinary income are explained in Publication 544. taxmap/pubs/p908-005.htm#en_us_publink1000137416
If a partnership's debt is canceled because of bankruptcy or insolvency, the rules for the exclusion of the canceled amount from gross income and for tax attribute reduction are applied at the individual partner level. Thus, each partner's share of debt cancellation income must be reported on the partner's return unless the partner meets the bankruptcy or insolvency exclusions explained earlier. Then all choices, such as the choices to reduce the basis of depreciable property before reducing other tax attributes, to treat real property inventory as depreciable property, and to end the tax year on the day before filing the bankruptcy case, must be made by the individual partners, not the partnership. taxmap/pubs/p908-005.htm#en_us_publink1000137417
For purposes of reducing the basis of depreciable property in attribute reduction, a partner treats his or her partnership interest as depreciable property to the extent of the partner's proportionate interest in the partnership's depreciable property. This applies only if the partnership makes a corresponding reduction in the partnership's basis in its depreciable property with respect to the partner. taxmap/pubs/p908-005.htm#en_us_publink1000137418
The allocation of an amount of debt cancellation income to a partner results in that partner's basis in the partnership being increased by that amount. At the same time, the reduction in the partner's share of partnership liabilities caused by the debt cancellation results in a deemed distribution, in turn resulting in a reduction of the partner's basis in the partnership. These basis adjustments are separate from any basis reduction under the attribute-reduction rules described earlier. taxmap/pubs/p908-005.htm#en_us_publink1000137419
Corporations in a bankruptcy proceeding or insolvency generally follow the same rules for debt cancellation and reduction of tax attributes as an individual or individual bankruptcy estate would follow.taxmap/pubs/p908-005.htm#en_us_publink1000137420
If a corporation transfers its stock (or if a partnership transfers an interest in the partnership) in satisfaction of indebtedness and the FMV of the stock or interest is less than the indebtedness owed, the corporation or partnership has income to the extent of the difference from the cancellation of indebtedness. The corporation or partnership can exclude all or a portion of the income created by the stock or interest debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent. However, the corporation or partnership must reduce its tax attributes to the extent it has any by the amount of the excluded income.taxmap/pubs/p908-005.htm#en_us_publink1000137421
The stock for debt exception was repealed for transfers made after 1994 unless the corporation filed for bankruptcy (or similar court proceeding) before 1994. Generally, before 1995, a corporation did not realize income because of such stock for debt exchanges if it was in bankruptcy or to the extent it was insolvent. Consequently, there was no gross income to exclude and no reduction of its tax attributes was necessary. The principal difference between the stock for debt exception and the stock for debt exchange is that the corporation does not reduce its tax attributes under the stock for debt exception. taxmap/pubs/p908-005.htm#en_us_publink1000137422
The earnings and profits of a corporation do not include income from the discharge of indebtedness to the extent of the amount applied to reduce the basis of the corporation's property as explained earlier. Otherwise, discharge of indebtedness income, including amounts excluded from gross income, increases the earnings and profits of the corporation (or reduces a deficit in earnings and profits).
If there is a deficit in the corporation's earnings and profits and the interest of any shareholder of the corporation is terminated or extinguished in a title 11 or similar case (defined earlier), the deficit must be reduced by an amount equal to the paid-in capital allocable to the shareholder's terminated or extinguished interest. taxmap/pubs/p908-005.htm#en_us_publink1000137423
For S corporations, the rules for excluding income from debt cancellation because of bankruptcy or insolvency apply at the corporate level.taxmap/pubs/p908-005.htm#en_us_publink1000137424
A loss or deduction that is disallowed for the tax year of the debt cancellation because it exceeds the shareholders' basis in the corporation's stock and debt is treated as an NOL for that tax year in making the required reduction of tax attributes for the amount of the canceled debt. taxmap/pubs/p908-005.htm#en_us_publink1000137425
The sample filled-in Form 982 shown on the next page is based on the following situation.
Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 2007, he reached an agreement with his creditors whereby they agreed to forgive $10,000 of the total that he owed them in return for his setting up a schedule for repayment of the rest of his debts.
Immediately before the debt cancellation, Tom's liabilities totaled $120,000 and the FMV of his assets was $100,000 (his total basis in all these assets was $90,000). At the time of the debt cancellation, he was considered insolvent by $20,000. He can exclude from income the entire $10,000 debt cancellation because it was not more than the amount by which he was insolvent.
Among Tom's assets, the only depreciable asset is a rental condominium with an adjusted basis of $50,000. Of this, $10,000 is allocable to the land, leaving a depreciable basis of $40,000. He has a long-term capital loss carryover to 2008 of $5,000. He also has an NOL of $2,000 and a $3,000 NOL carryover from 2005. He has no other tax attributes arising from the current tax year or carried to this year.
Ordinarily, in applying the $10,000 debt cancellation amount to reduce tax attributes, Tom would first reduce his $2,000 NOL, next, his $3,000 NOL carryover from 2005, and then his $5,000 net capital loss carryover. However, he figures that it is better for him to preserve his loss carryovers for the next tax year.
Tom elects to reduce basis first. He can reduce the depreciable basis of his rental condominium (his only depreciable asset) by $10,000. The tax effect of doing this will be to reduce his depreciation deductions for years following the year of the debt cancellation. However, if he later sells the condominium at a gain, the part of the gain from the basis reduction will be taxable as ordinary income.
Tom must file Form 982, as shown here, with his individual return (Form 1040) for the tax year of the debt discharge. In addition, he must attach a statement describing the debt cancellation transaction and identifying the property to which the basis reduction applies. This statement is not illustrated.