TAXATION OF
CANCELLATION OF DEBT
Canceled Debt
• Generally speaking, if a debt for which you
are personally is canceled or forgiven,
other than by gift, you must include the
canceled amount in income.
• Debt for which you are personally liable is
recourse debt.
Canceled Debt
• If you do not have personal liability for the
debt, you do not have ordinary income
from cancellation of debt unless
• the lender agrees to discount the debt for
early payment ( i.e. a short sale) or
• agrees to a loan modification that results
in a the reduction of the principal balance
of the debt.
Canceled Debt
• If the lender offers to reduce the principal
balance of a loan if it is paid off early (i.e. a short
sale),
• or agrees to a loan modification that reduces the
principal balance of the loan,
• the amount of the principal reduction is
canceled debt whether or not you are personally
liable for the debt.
Rules on Sales or Dispositions
• NON-RECOURSE DEBT – Foreclosure
• The entire debt on property subject to nonrecourse debt is treated as the amount realized
on the disposition of the property.
• Any amount in excess of the FMV of the
property does not result in ordinary income.
Rules on Sales or Dispositions
• RECOUSE DEBT:
• If the property was subject to recourse debt in excess of
the FMV of the property,
• the amount of the debt in excess of the FMV may result
in ordinary income from cancellation of debt.
• Taxable income has several components:
– The gain or loss measured by the difference between the FMV of
the property minus the adjusted basis of the property.
– The ordinary income from the canceled debt over the FMV of the
property.
Exclusions
• Insolvency
• Qualified Farm Indebtedness
• Qualified Principal Residence
Indebtedness
• Qualified Real Property Indebtedness
Insolvency
• To the extent you were insolvent
immediately before the cancellation of
debt, you do not have cancellation of debt
income.
• Insolvency is determined to the extent the
total of all your liabilities exceeded the
FMV of all of your assets immediately
before the cancellation.
Qualified Principal Residence Debt
• You can exclude COD from income if it is
qualified principal residence debt.
• Qualified principal residence debt is debt
acquired to acquire, construct or
substantially improve your principal
residence.
• Maximum amount is $2,000,000
($1,000,000 MFS)
Qualified Real Property Business Debt
• Incurred or assumed in connection with real
property used in a trade or business.
• Secured by such real property.
• Incurred or assumed before 1993 or after 1992.
• Debt to which you elect to apply these rules.
• There are a number of limiting rules that apply to
this exclusion that require a detailed analysis of
the individual’s facts and circumstances.
Comprehensive Example
• John & Patricia purchased a new home in
2006 for $3,000,000. They put down
$400,000 and took out a non-recourse
loan in the amount of $2,600,000. By
August, 2009, their property value had
fallen to $1,750,000.
Non-Recourse Analysis
• If the original loan was non-recourse, and they
turned the property over to the lender in
December, 2009 either through foreclosure or
deed in lieu, the tax consequence would be as
follows:
Non-Recourse Analysis
• Sales Price
• Cost Basis
• Non Deductible Loss
$2,500,000
(3,000,000)
500,000
• The sales price is deemed to the
CURRENT balance of the loan at the time
of the foreclosure.
Recourse Analysis
• Gain or Loss on Sale:
• Foreclosure Sale
• Cost Basis
• Non deductible loss
$1,750,000
(3,000,000)
1,250,000
Recourse Analysis
•
•
•
•
•
•
Insolvency Analysis:
Assets:
Cash in bank
Retirement account
Auto
Total
$ 15,000
17,000
10,000
42,000
•
•
•
•
Liabilities:
Remaining balance on loan
Credit cards
Total
$750,000
18,000
768,000
• Amount of Insolvency
$726,000
Recourse Analysis
• Qualified Principal Residence Debt Exclusion:
• Debt:
• Max Exclusion
• Amt not qualifying
$2,500,000
(2,000,000)
500,000
• Amount of Debt Forgiveness
• Less Amt not qualifying
• Amount eligible for exclusion
•
$750,000
(500,000)
250,000
Recourse Analysis
•
Taxpayer cannot both the Qualified Residence Debt Exclusion and the the
Insolvency Exclusion for the amount of Qualified Residence Debt but can
elect to the Insolvency Exclusion instead of the QRDE.
•
In this example, John and Patricia do not elect the insolvency exclusion for
the amount of the Qualified Residence Debt and they exclude $250,000 of
that debt under that rule.
•
Since $500,000 of the original debt was not eligible for the Qualified
Residence Debt ($2,500,000 – 2,000,000= 500,000), John and Patricia can
still apply the Insolvency Exclusion to the remaining $500,000 of Cancelled
Debt Income.
•
•
•
Cancelled Debt
Less QRDE
Remaining COD
$ 750,000
(250,000)
500,000
•
Insolvency
(726,000)