Taxpayer Relief–Excluding Canceled Debt from Income

Over the past few years, many taxpayers have suffered losses due to the economy.  For some, there may be a small sense of relief related to cancellation of debt income and excluding it from taxable income.  Certain “discharge of indebtedness” exclusions may apply.

Anyone receiving a Form 1099-C Cancellation of Debt or 1099-A Acquisition or Abandonment of Secured Property should be aware of these rules and the potential tax savings. As a general rule, cancellation of indebtedness income is excluded from income if one of the following circumstances applies:

  • The discharge occurs in a title 11 case.
  • The discharge occurs when the taxpayer is insolvent.
  • The indebtedness discharged is qualified farm indebtedness.
  • The indebtedness discharged is qualified real property business indebtedness.
  • The indebtedness discharged is qualified residence indebtedness which is discharged before January 1, 2014.

Title 11 Case

Taxpayers may exclude from income all debt canceled in a title 11 bankruptcy case.  A “title 11 case” means a bankruptcy case under title 11 of the United States Code (including all chapters in title 11 such as chapters 7, 11, and 13). The exclusion applies only if the taxpayer is under the jurisdiction of the court and the discharge of debt is granted by the court or occurs as a result of a plan approved by the court.

Insolvency

A little-known rule is that taxpayers may exclude from income debt canceled to the extent they were insolvent immediately before the discharge of the debt. A taxpayer is “insolvent” when his or her liabilities exceed the fair market value (FMV) of their assets. For purposes of determining insolvency, assets include the value of everything a taxpayer owns including assets exempt from the claims of creditors in a bankruptcy case. (For example, the value of a principal residence, retirement plans, or personal vehicle must be included in calculating insolvency). Liabilities include both recourse and nonrecourse debt.

Qualified Farm Indebtedness

Taxpayers can exclude canceled farm debt from income as long as the debt was incurred in direct connection with the operation of the trade or business of farming, subject to certain restrictions and conditions.

Qualified Real Property Business Indebtedness

Taxpayers may elect to exclude canceled qualified real property business indebtedness from income as long as the debt was either incurred or assumed before 1993 or, if incurred after 1993, the debt is qualified acquisition indebtedness, in connection with real property used in a trade or business and it is secured by that real property.

Qualified Residence Indebtedness

Taxpayers can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage which is secured by your main home and that a taxpayer took out to buy, build, or substantially improve their main home. Qualified principal residence indebtedness also includes any debt secured by a main home that is used to refinance a mortgage, but only up to the amount of the old mortgage balance prior to the refinancing. This exclusion applies to qualified discharges occurring on or after January 1, 2007, and before January 1, 2014, and is limited to $2 million. The 2013 tax year is the last year a taxpayer may take advantage of this exclusion.

For more information about excluding canceled debt from income, contact the experts listed below at PYA.


Eric Elliott

Eric Elliott

Principal

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