Here at Shenwick & Associates, many clients come to us looking to wipe out their debts, usually through bankruptcy or a workout (but we also represent creditors). While the cancellation of debts is desirable, the problem is that the IRS considers the cancellation of debt to be gross income under § 108 of the Internal Revenue Code.
However, there are exceptions to inclusion and exclusions to cancellation of debt (COD) income:
Exceptions to inclusion from gross income are:
- Amounts specifically excluded from income by law, such as gifts or bequests (personal property received upon the death of the donor).
- Cancellation of certain qualified student loans. Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. If a student loan is canceled as the result of this type of provision, the cancellation of this debt is not included in the recipient’s gross income. If a taxpayer uses the cash method of accounting rather than the accrual method, the taxpayer does not realize cancellation of debt income if the expense would have otherwise been deductible.
- A qualified purchase price reduction given by a seller. If debt you owe the seller for the purchase of property is reduced by the seller at a time when you are not insolvent and the reduction does not occur as the result of a bankruptcy, the reduction does not result in cancellation of debt income. However, you must reduce your tax basis in the property by the amount of the reduction of your debt to the seller.
Exclusions from gross income are:
- Cancellation of qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing. The exclusion for qualified principal residence indebtedness provides canceled debt tax relief for many home owners involved in the mortgage foreclosure crisis. The exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of qualified principal residence indebtedness.
- Debt cancelled in a bankruptcy case.
- Debt canceled during insolvency (which is the extent that the total of all of your liabilities was more than the fair market value of all of your assets immediately before the cancellation.
- Cancellation of qualified farm indebtedness.
- Cancellation of qualified real property business indebtedness, which is debt that (a) was incurred or assumed in connection with real property used in a trade or business; (b) secured by that real property; and (c) was incurred or assumed before 1993, or after 1992, if the debt is either (i) qualified acquisition indebtedness or (ii) debt incurred to refinance qualified real property business debt incurred or assumed before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced).
For more information about how cancellation of debts can affect your income and taxes, please contact Jim Shenwick.
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