With the current economy as it is, cancellation of debt (COD), which is reported on Form 1099C, is going to be a more common occurrence to both individuals and companies. In general, when a debt is canceled or forgiven and it is not a gift, it must be included in income. However, the amount of income to include and where on the return to report it may vary. Reviewing this type of transaction and minimizing the tax related to the cancellation of debt is a service we can provide.
Treatment of Interest (Assuming no exclusions are met)
Box 3 of Form 1099C will show any forgiven interest that is included in the total cancelled debt reported in box 2. Whether interest on the canceled debt is reportable income depends on whether the interest would have been deductible if paid.
If the interest would not have been deductible (such as on a personal car loan), the interest is included in income when forgiven. If the interest would have been deductible (such as on a business loan), then it is not included in income when forgiven so the interest needs to be deducted from box 2.
Exclusions from general rule of including COD in income
There are several circumstances when COD does not need to be included in income. Generally, if COD was excluded under one of these scenarios, the tax attributes of the taxpayer need to be reduced. Some of the major exclusions are bankruptcy, insolvency, qualified real property business indebtedness, and qualified principal residence indebtedness. Other exclusions are also available. Some of these exclusions must be used before the other one applies. Each taxpayer situation needs to be evaluated separately but it’s important to remember that they are available and not all COD is necessarily taxable.
If the debt was cancelled due to a Title 11 bankruptcy case, the COD is not included in income. The debtor must be under the jurisdiction of the court in this case.
Cancelled debt is not included in income if the individual or business is insolvent immediately before the cancellation. Insolvency is measured by the excess of total liabilities over the fair market value of total assets held by the taxpayer.
Assets include cash, residences, cars, stocks, bonds, mutual funds, and other personal items. Assets also include interests in pension plans, education accounts, cash value of life insurance, investments in businesses and all other investments. If the debt is related to real or personal property, this property is also included in the value of total assets.
Liabilities include mortgages, credit card debt, car loans, loans against life insurance or pension plans, business debt, accrued or past due amounts related to interest, taxes, utilities, and all other debt. The debt forgiven is included in the liabilities and if the debt was secured by any property, that property is included in the assets since this is all measured immediately before the cancellation of debt.
The amount excluded from income is the smaller of the amount of debt cancelled or the amount of insolvency before cancellation. Therefore, if liabilities exceed assets by $10,000 and the cancellation of debt was $50,000, $40,000 of the COD is to be included in income.
- Qualified Real Property Business Indebtedness
This exclusion applies to debt related to real property used in a trade or business which is secured by such property. This exclusion does not apply if the taxpayer is in a Title 11 bankruptcy or if the taxpayer was insolvent immediately before the cancellation of debt. If applicable, the bankruptcy and insolvency exclusions must be applied first.
This exclusion is limited to the excess of the outstanding real property business debt over the fair market value of the real property secured by such debt less any other debt secured by the same property. It is further limited to the total adjusted basis of depreciable real property held before the cancellation. The reduction of tax attributes (discussed below) may affect this amount.
- Qualified Principal Residence Indebtedness
This is any debt incurred in acquiring, constructing or substantially improving a principal residence and is secured by this residence. It also includes debt from re-financing the debt related to principal residence. A principal residence is the home where an individual ordinarily lives most of the time. This exclusion cannot be used in where a Title 11 bankruptcy situation exists.
Reduction of Tax Attributes
If cancelled debt is excluded from income, certain tax attributes must be reduced. Which attributes get reduced depends on what assets are held by the taxpayer, the reason the debt was excluded from income and potential elections made by the taxpayer. The attributes can not be reduced below zero.
Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
Every taxpayer (whether they be individuals or business entities) that does not report 100% of the amount reported to them on 1099-C must file Form 982. The reason the amount is excluded is reported on lines 1a-1f and the amount excluded is reported on line 2. The reduction of attributes or basis is reported in Part II of this form.
If you have any questions related to the cancelation of debt, please contact our Tax Planning and Preparation Department at 440-449-6800.