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Forgiveness of Debt
Individuals often borrow money to purchase property or obtain funds for business or personal spending. A decline in someone’s economic circumstances may sometimes make it difficult for people to pay back this debt.
When someone finds it difficult, or impossible, to pay back debt creditors sometimes agree to reduce or cancel the liability. Depending on the circumstances, this cancellation of indebtedness (COI) can generate taxable income. However, there are exclusions and exceptions to the recognition of income:
• The taxpayer will not have to recognize COI income if the debtor is:
o Bankrupt
o Insolvent, or
o A disaster victim
• Other exclusions are tied to the nature of the debt, such as:
o Farm debt
o Debt from real estate used in business
o Principal residence debt
o Debt from student loans
Discharge of Debt
COI income results from the discharge of debt and is treated as ordinary income. A discharge occurs when the creditor accepts less than the full amount of the debt as full payment. The debtor’s circumstances (such as filing for bankruptcy) may trigger a discharge. If the debt is discharged, the COI income is the difference between the face value of the debt and the amount paid by the debtor that is treated as satisfying the debt.
The idea that having to pay taxes on something that was never received as actual cash income is sometimes hard for taxpayers to understand. The thinking behind the tax code on this is that the taxpayer who had debt relieved has had a real economic benefit from having that debt relieved. This economic benefit is taxable.
There are a number of potential exclusions that apply to a debtor who has COI income, these are as follows:
• Insolvency –the debtor’s total liabilities must exceed the total value of debtor’s assets. It is not necessary to go through formal bankruptcy to get tax relief from this provision.
• Bankruptcy - a discharge by court order involving liquidation, reorganization, or wage earners plan.
• Farm debt – either debt on property or the farmer’s personal debt, incurred in the farming business.
• Real property business debt – debt to acquire, construct, or substantially improve property used in a trade or business.
• Principal residence debt – up to $2 million of debt to buy, construct, or substantially improve a principal residence if the discharge occurs before 2012
• Student loans – applies to students working in certain professions: law, medicine, and teaching.
• Disaster and terrorism victims – temporary exclusion for discharges of personal debt for victims of specified events during certain dates.
• Gifts and bequests that discharge personal debt – generally not business debt.
• General welfare payments – for some government payments that are not taxable because they promote the general welfare, like housing assistance or job training.
It is important to note that the tax rules for COI can be different for S-Corporations, Partnerships, C-Corporations as well as individuals and the above rules can have some twists and turns that should be reviewed. Should you find yourself with the possibility of COI income, feel free to contact our office for guidance.
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