Intermediate Cancellation of Debt 2009 Chapter Summaries

Intermediate Cancellation of Debt 2009

Chapter 1

Cancellation of Debt occurs when a lender/seller cancels or forgives a debt. Generally, the debtor/buyer will have taxable income from a cancellation of debt.

Recourse vs. Nonrecourse debt:

• Recourse debt occurs when the buyer is personally responsible for the full amount of the debt, even if the property that secures it is worth less than the debt. With recourse debt, the lender may be able to collect any shortfall (deficiency) from the buyer’s other assets and income. If the buyer does not collect the deficiency, the cancelled amount is income from cancellation of debt.

• Nonrecourse debt occurs when the buyer is only responsible for the debt up to the value of whatever property secures the debt. If there is a deficiency, the lender cannot collect from other assets or income of the buyer, and there will be no income from cancellation of debt.

Cancelled debt is reported to the buyer on Form 1099-C. If the debt is personal debt, the tax preparer will report it on form 1040, line 21. If the debt is business debt, it would be reported on the business form (Schedule C, E, or F most often.)

In a foreclosure or other surrender of property, there may be debt that is not satisfied by the value of the property. If the debt is recourse debt and the seller does not collect this deficiency from the buyer, there will be ordinary income from the cancelled debt.

A buyer may also have cancelled debt from unsecured debt such as credit cards or student loans. This debt is usually ordinary income from cancellation of debt.




Exceptions and Exclusions:

Exceptions:

• Gift: if the debt is cancelled as a gift, no income is recognized
• Deductible debt: if the debt would have been deductible if paid, no income is recognized
• Purchase price reduction: buyer is solver, but seller reduces purchase price and forgives part of the debt from the original purchase
• Nonrecourse debt
• Student loans: There are some programs that allow student loan debt to be forgiven for students who work in certain states in specific professions. If the terms of the forgiveness program are met, no income is recognized. (Kentucky has Best in Care and Best in Class)

Exclusions (must be applied in this order):

• Debt cancelled in Title 11 bankruptcy**
• Debt cancelled when the buyer is insolvent (has more debts than assets), excludible to the extent of insolvency
• Qualified Midwestern disaster area indebtedness
• Qualified farm indebtedness
• Qualified real property business debt
• Qualified principal residence indebtedness

**Chapters 7, 11, and 13 bankruptcies all fall under Title 11. Chapter 11 is most often used for businesses. Chapter 13 has a pay-down plan; Chapter 7 is usually a write-off.

Reporting Cancellation of Debt

Form 1099-A: If a client has a foreclosure Form 1099-A that shows recourse debt and a FMV less than the outstanding debt amount, there may be cancellation of debt income. If the client has not also received a Form 1099-C, you may need to research to determine whether the deficiency is still owed or has been cancelled.


Form 1099-C: Debts of $600 or more than are cancelled should generate a Form 1099-C. This includes personal debt, student loan debt, and secured/real property debt.

Remember the Recourse/Nonrecourse rule: if cancelled debt is recourse, there is income. If cancelled debt is nonrecourse, there is no income.

Purchase Price Reduction vs. Loan Workout:
This is an exception to the nonrecourse rule!

• Situation 1: lender (who is also property seller) agrees to reduce purchase price after the sale is final, reduction of debt is not taxable income to buyer. This is a Purchase Price Reduction.
• Situation 2: lender (who is not property seller) agrees to reduce debt amount after sale is final, reduction of debt is taxable to buyer even if nonrecourse. This is a Loan Workout or Loan Restructuring.

Chapter 2

Reduction of Tax Attributes and/or Basis

If any income from cancellation of debt will be excluded, the taxpayer’s tax attributes must be reduced, using Form 982.

Tax attributes are certain deductions and credit carryovers that reduce either taxable income or tax liability.

Tax attributes are reduced in a certain order, depending on the reason for the exclusion.

Bankruptcy, Insolvency, and Midwestern Disaster Area indebtedness:
If the only tax attributes are personal property basis, reduce the basis in personal property. If there are other tax attributes, reduce them in this order:

1. Net Operating Loss (NOL) (NOL from year of discharge first, then carryovers)
2. General business credit carryovers
3. Minimum tax credit
4. Net capital losses
5. Basis of property (other than money)
6. Passive activity loss or credit carryovers
7. Foreign tax credit carryovers

Election to Reduce Basis First:
A taxpayer may elect to reduce basis in depreciable property before reducing other tax attributes. This basis reduction will be treated as depreciation claimed when the property is sold or disposed of.

Principal Residence: If the taxpayer is using the qualified principal residence exclusion to exclude cancellation of debt income and the taxpayer continues to own the home, their basis of the residence must be reduced by the amount of excluded income.

Forms and worksheets:
Statement of Income from Discharge of Indebtedness is used to figure taxable income from the discharge of indebtedness in bankruptcy or insolvency, or as qualified farm indebtedness.

• Note: Our Peace of Mind claims department will require this statement for all returns that have a claim due to cancelled debt, even if the taxpayer was not insolvent.

Form 982 is used to reduce tax attributes (in order) after exclusion amount is determined on the Statement of Income from Discharge of Indebtedness.

Insolvency
A taxpayer is insolvent if his/her debts exceed his/her assets immediately preceding the discharge of debt. (Also known as “negative net worth”.)


Special Rules for Mortgage Debt Forgiveness:

• Under the 2007 Mortgage Forgiveness Debt Relief Act, there are special tax breaks for home owners who have mortgage debt forgiven. If qualified, a taxpayer may exclude cancellation of debt income that would otherwise be taxed.
• Tax relief only applies to purchase price plus cost of improvements.
• Principal residence only (no vacation homes or business property).
• Not permanent: only applies in 2007, 2008 and 2009.
• Limited to $2 million.
• When this relief is applied, taxpayer’s basis in the property is reduced by the excluded amount.