Debt cancellation income rules effect on taxes

General rule. Gross income includes income from the discharge of indebtedness. This applies equally to debts discharged by commercial lenders and those canceled by private lenders.  However, there are several exceptions to the general rule that treats a debt forgiveness as taxable. In addition, there are numerous exclusions from gross income for certain types of forgiven debts. Exceptions and exclusions are separately covered below.  If you have specific questions call our office at 407-677-1040. 

Gift exception. If a debt cancelled by a private lender, such as a relative or friend, is intended as a gift, there is no income. Likewise, a debt cancelled by a private lender's Last Will and Testament triggers no income to the borrower.

Student loan exception. There is an exception for certain student loans. In the case of an individual, gross income doesn't include any amount which (but for this rule) would be includible in gross income by reason of the discharge of all or part of any student loan if the discharge was made under a provision of the loan that all or part of the indebtedness would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of employers. For example, doctors, nurses, and teachers agreeing to serve in rural or low income areas in exchange for cancellation of their student loans won't have income from the cancellation if they meet certain conditions.

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Exception for deductible debt. There is no income from cancellation of deductible debt. For example, if a lender cancels home mortgage interest that could have been claimed as an itemized deduction on Schedule A of Form 1040, there is no

Price adjustment. There is no income if an individual purchases property and the seller later reduces the price.  The purchaser's basis in the property, however, is reduced by the amount of the purchase price adjustment. 

Discharge of debt through bankruptcy. No amount is included in a debtor's gross income by reason of a discharge of indebtedness in a Title 11 (bankruptcy) case, but only if the taxpayer is under the jurisdiction of the court in such a case and the discharge is granted by the court or in a court-approved plan. The amount of discharged debt which thus is excluded from the debtor's gross income must be applied to reduce certain of his tax attributes unless he elects to reduce his basis in depreciable assets or in real property held as inventory.

Discharge of debt of an insolvent taxpayer. A debtor may be insolvent (although not in bankruptcy) when his indebtedness is discharged. In this case, the amount of debt discharge is excluded from the debtor's gross income, up to the amount of his insolvency.   The amount excluded under this insolvency exception is applied to reduce the debtor's tax attributes in a specified manner.   Or the insolvent debtor may elect to reduce his basis in depreciable assets or in real property held as inventory. 

Discharge of qualified farm debt. The discharge of qualified farm indebtedness by a qualified person outside of bankruptcy doesn't generate cancellation of debt income to a solvent taxpayer.  This qualified farm indebtedness exclusion is applied after the insolvency and Title 11 (bankruptcy) exclusions. Thus, it doesn't apply to the extent the debtor is insolvent or to a debtor in Chapter 11 bankruptcy.   The excluded amount of discharged qualified farm indebtedness can't exceed the sum of the taxpayer's adjusted tax attributes plus the aggregate adjusted bases of qualified property he holds at the beginning of the tax year following the tax year in which the discharge occurs.

Discharge of qualified real property business debt. A discharge of qualified real property business indebtedness of a solvent taxpayer other than a C corporation outside of bankruptcy doesn't result in cancellation of debt income (subject to a limit).  The amount excluded from gross income is applied to reduce the basis of the taxpayer's depreciable real property.

Discharge of qualified principal residence debt. Any discharge of indebtedness income by reason of a discharge (in whole or in part) of qualified principal residence indebtedness (below) is excluded from the taxpayer's gross income.  This exclusion applies where a taxpayer restructures his acquisition debt on a principal residence, loses his principal residence in a foreclosure, or sells a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance). The taxpayer's basis in the residence must be reduced. “Qualified principal residence indebtedness” is acquisition indebtedness on the taxpayer's principal residence, up to a $2 million limit ($1 million for married individuals filing separately). 

There are some other situations that are not includable in income as well.  The best way to determine how these rules affect you is to contact an experienced tax professional.