Debt Cancellation

Generally, if a debt for which you are personally liable is cancelled or forgiven, other than as a gift or bequest, you must include the cancelled amount in your income. A debt includes any indebtedness (1) for which you are liable, or (2) subject to which you hold property. A lender will issue a Form 1099-C to report a Cancellation of Debt.

Debt Cancellation & Foreclosure Gain Worksheet

Recourse Debt

Debt for which you are personally liable is recourse debt.

Reduction of Principal

If you are not personally liable for the debt, you do not have ordinary income from the cancellation of debt unless the lender (1) offers a discount for the early payment of the debt, or (2) agrees to a loan modification that results in a reduction of principal balance of the debt.

Discount for Early Payment

If you are not personally liable for the debt, you do not have ordinary income from the cancellation of debt unless the lender (1) offers a discount for the early payment of the debt, or (2) agrees to a loan modification that results in a reduction of principal balance of the debt.

Gifts

A creditor’s cancellation of a debt as a gift to the debtor does not result in income to the debtor.

Loan Secured by Property

If you have property that is security for a debt and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have a gain or loss as a result. For this purpose, it does not matter whether the lender took the property through foreclosure, repossession, a voluntary conveyance by you to the lender, or your abandonment of the property.

Further, if the lender cancels recourse debt in excess of the fair market value (FMV) of the property taken by the lender, the excess of the cancelled debt over the FMV of the property may have to be treated by you as ordinary income from the cancellation of debt in addition to any gain that you may have from being treated as having sold the property.

However, if you own property that was subject to a nonrecourse debt in excess of the FMV of the property, the lender’s foreclosure on the property does not result in ordinary income from the cancellation of debt.

If debt you owe the seller for the purchase of property (i.e. seller carryback note) is reduced by the seller at a time when you are not insolvent and the reduction does not occur in a title 11 bankruptcy case, the reduction does not result in cancellation of debt income. However, you must reduce your basis in the property by the amount of the reduction of your debt to the seller.

A lender will issue Form 1099-A to report the acquisition of property resulting from a foreclosure or repossession.

Principal Residence

You can exclude cancelled debt from income if it is Qualified Principal Residence Indebtedness.

Other Real Property

You can exclude cancelled debt from income if it is Qualified Real Property Business Indebtedness.

Personal Property

Generally, cancellation of indebtedness secured by personal property is not eligible for relief from cancellation of indebtedness income.

Eligible for Relief

Cancellation of indebtedness relating to your principal residence may be excluded if it is 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.

Cancellation of indebtedness relating to other real property may be excluded if it is Qualified Real Property Business Indebtedness. Qualified Real Property Business Indebtedness is debt (other than qualified farm debt) that meets all of the following conditions.

1. It was incurred or assumed in connection with real property used in a trade or business.
2. It is secured by that real property.
3. It was incurred or assumed:
   1. Before 1993, or
   2. After 1992, if the debt is either (i) Qualified Acquisition Indebtedness, or (ii) debt incurred to refinance Qualified Real Property Indebtedness incurred or assumed before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced).
4. It is debt to which you elect to apply these rules.

Definition of Qualified Acquisition Indebtedness — Qualified Acquisition Indebtedness is:

• Debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property that is used in a trade or business and secures the debt, or
• Debt resulting from the refinancing of qualified acquisition indebtedness, to the extent the amount of the debt does not exceed the amount of debt being refinanced.

(i) Qualified Principal Residence Indebtedness

You can exclude cancelled debt from income if it is Qualified Principal Residence Indebtedness.

(ii) Qualified Real Property Business Indebtedness

You can exclude cancelled debt from income if it is Qualified Real Property Business Indebtedness.

Excludable

The maximum exclusion limit for:

Qualified Principal Residence Indebtedness - is $2 million ($1 million if married filing separately). If only a part of a loan is Qualified Principal Residence Indebtedness, the exclusion applies only to the extent the amount cancelled is more than the amount of the loan (immediately before the cancellation) that is not Qualified Principal Residence Indebtedness. The remaining part of the loan may qualify for another exclusion (see insolvency).

Qualified Real Property Business Indebtedness — is limited to the excess (if any) of:

• The outstanding principal amount of the qualified real property business debt (immediately before the cancellation), over
• The FMV (immediately before the cancellation) of the business real property securing the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property (immediately before the cancellation).

In addition to this limit, a second overall limit applies. The amount of cancelled qualified real property business debt you can exclude from income cannot be more than the total adjusted basis of depreciable real property you held immediately before the cancellation of the qualified real property business indebtedness (other than depreciable real property acquired in contemplation of the cancellation).

Title 11 Bankruptcy

Debt cancelled in a title 11 bankruptcy case (including chapters 7, 11, and 13) is not included in your income if 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.

Insolvency

Cancelled debt is not included in income to the extent you were insolvent immediately before the cancellation. You are considered insolvent to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of creditors, such as your interest in a pension plan and the value of your retirement account).

Your liabilities include:

• The entire amount of recourse debts,
• The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and
• The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.

IRS Publication 4681 includes a convenient and easy-to-follow Insolvency Worksheet.

Insolvency Worksheet

Partial Insolvency

Partial insolvency occurs when the amount of the insolvency is less than the cancelled debt. In the case of partial insolvency, cancelled debt income can only be excluded to the extent of debtor insolvency under the insolvency exclusion.

Reporting of Cancellation of Indebtedness Income

You must report any taxable cancelled debt as ordinary income on:

• Form 1040 or 1040NR, line 21, if the debt is nonbusiness debt;
• Schedule C (Form 1040), line 6 (or Schedule C-EZ) (Form 1040), line 1), if the debt is related to a nonfarm sole proprietorship;
• Schedule E (Form 1040), line 3, if the debt is related to nonfarm rental of real property;
• Form 4835, line 6, if the debt is related to a farm rental activity for which you use Form 4835 to report farm rental income based on crops or livestock produced by a tenant; or
• Schedule F (Form 1040), line 10, if the debt is farm debt and you are a farmer.

Form 982; Reduction of Tax Attributes

If you exclude cancelled debt from income, you must reduce certain tax attributes (but not below zero) by the amount excluded. IRS Form 982 is used for this purpose. The order in which the tax attributes are reduced depends on the reason the cancelled debt was excluded from income.

Tax attributes include the following:

• Net Operating Loss (NOL)
• General Business Credit Carryover
• Minimum Tax Credit
• Capital Loss
• Property basis, including
  • Real Property
  • Personal Property (except inventory and accounts and notes receivable) used in a trade or business or held for investment
  • Other Property (except inventory, accounts receivable, notes receivable and real property held primarily for sale to customers) used in your trade or business or held for investment
  • Inventory, accounts receivable, notes receivable, and real property held primarily for sale to customers
  • Personal use property (property not used in your trade or business nor held for investment).
• Passive Activity Loss and Credit Carryover
• Foreign Tax Credit

Form 982 — Reduction of Tax Attributes

Ownership Relinquished

The foreclosure or repossession of your property is treated as a sale from which you may realize a gain or loss. This is true even if you voluntarily return the property to the lender. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized.

Debt Exceed Basis

To the extent that the amount of debt cancelled exceeds the adjusted basis of property securing the cancelled debt, you will have a gain that will generally have to be reported on your income tax return in addition to any reportable income resulting from the cancellation of indebtedness.

If you are personally liable for the debt (i.e. recourse debt), the amount realized on the foreclosure or repossession includes the smaller of:

• The outstanding debt immediately before the transfer reduced by any amount for which you remain personally liable immediately after the transfer, or
• The FMV of the transferred property

The amount realized also includes any proceeds you received from the foreclosure sale.

If you are not personally liable for the debt (i.e. nonrecourse debt), the amount realized includes the full amount of the outstanding debt immediately before the transfer. This is true even if the FMV of the property is less than the outstanding debt immediately before the transfer.

Report GAIN from Disposition

Any gain from the disposition of property resulting from foreclosure, repossession, short sale or abandonment must be reported on your income tax return.

Report LOSS from Disposition

A loss from disposition of business, trade, or investment property resulting from foreclosure, repossession, short sale, or abandonment may be deducted on your income tax return.

Business / Rental Form 4797

Gain or loss resulting from the disposition of property (real and personal property) used in a trade or business or a rental activity should be reported on Form 4797.

Investment Schedule D

Gain or loss resulting from the disposition of property held for investment purposes should be reported on Form 1040, Schedule D.

Residential Property Schedule D

Gain resulting from the disposition of residential property not held for rental or investment purposes (i.e. vacation and second homes) should be reported on Form 1040, Schedule D.

Principal Residence

Gain resulting from the disposition of your principal residence to the extent not excludable under IRC Section 121 (Exclusion of Gain from Sale of Principal Residence), should be reported on Form 1040, Schedule D.

IRC Section 121 Exclusion

IRC Section 121; Exclusion of Gain from Sale of Principal Residence — Gain from the disposition of your principal residence resulting from foreclosure, repossession, short sale or abandonment may qualify for exclusion. The maximum amount of gain excludable under IRC Section 121, subject to eligibility, is $250,000, or $500,000 if married filing jointly.

Business or Investment Property

(including Property used in Rental Activities) — Loss from the disposition of property used in a trade or business or used in a rental activity resulting from a foreclosure, repossession, short sale, or abandonment may be deductible on your income tax return.