With the state of the economy, more and more taxpayers are finding themselves in transactions involving cancellation of debt (COD). According to the Internal Revenue Service, COD is a taxable event and must be included in gross taxable income. There are many exceptions to the rules for the tax treatment of COD income, so a careful examination of one's COD income is critical in determining potential tax consequences.

Banks, other financial institutions, and certain government agencies generally must report COD income (partial or complete) on Form 1099-C (Cancellation of Debt) if the COD income is $600 or more. The cancelled amount includes any amount owed to the lender that is forgiven, including loan principal, interest, penalties, administrative costs, and fines.

Cancellation of a debt (other than as the result of a gift) results in gross income for the debtor unless an exception applies because of bankruptcy or insolvency, or the debt is qualified farm debt, qualified real property business debt, a certain type of student loan, or qualified principal residence indebtedness. A special rule applies to a reduction of a seller-financed (i.e., purchase money) debt owed to the seller of the property. 

When a taxpayer is in bankruptcy (title 11), no income is recognized on the cancellation of debt. A title 11 case is one that falls under title 11 of the United States Code and encompasses the federal bankruptcy statutes including Chapter 7 (liquidation), Chapter 11 (business reorganization), Chapter 12 (family farmer or fisherman), and Chapter 13 (adjustment of an individual's debts) bankruptcies. The debt must be discharged by a court order or pursuant to a plan approved by the court. The taxpayer can be solvent after discharge and still get the exclusion, as bankruptcy takes precedence over the insolvency exclusion.

Under the insolvency exclusion the taxpayer may exclude COD that occurs while insolvent up to the amount of insolvency. Any COD income in excess of insolvency is taxable income. The extent of insolvency is the excess of the taxpayer's liabilities over the FMV of his assets immediately before the debt cancellation. When determining insolvency, assets include the value of everything owned including assets that are collateral for debt and exempt assets that are excludable in bankruptcy such as retirement plans. Liabilities include the entire amount of recourse debt, nonrecourse debt to the extent of the FMV of the property securing the debt, and contingent liabilities if "it is more probable than not" that the debtor will have to pay (the burden of proof is on the taxpayer).

While both bankrupt and insolvent taxpayers can exclude COD income from taxable gross income, they must reduce certain tax attributes to the extent possible. The reduction of tax attributes means that some or all of the excludable COD income will eventually be includable in gross income or the basis of the property.

When COD occurs in a partnership, the determination of solvency and the reduction of attributes occur at the partner level. The partnership reports the COD income and each partner is allocated a distributive share to be excluded/included based on the individual partner's circumstances. When COD occurs in a subchapter S Corporation, the COD income is taken into account at the entity level. COD income at the entity level does not flow through to the individual shareholders as an item of income.

There are special rules for farmers. Farmers do not have to recognize COD income if the debt forgiven is qualified farm indebtedness. For the COD income to be excluded from gross taxable income the debt must have been incurred in the business of farming, at least 50% of the taxpayer's gross receipts from all sources for the preceding 3 years were attributable to the business of farming, and the lender is unrelated to the taxpayer and is actively engaged in the business of lending money or is a governmental agency.

For a taxpayer who incurs COD income from the discharge of debt in a qualified real property business, debt includes debt incurred or assumed in connection with real property used in a trade or business that is secured by such real property; and incurred or assumed before 1993 or after 1993, and is qualified acquisition debt (debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business). Qualified real property debt includes refinanced qualified real property business debt to the extent of the original debt, not an excess amount refunded with the refinance. The COD income exclusion is limited to the outstanding principal amount of the debt (immediately before the cancellation) over the FMV of the real property securing the debt. The overall limitation is that the cancelled debt cannot exceed the total adjusted basis of all depreciable real property held by the taxpayer immediately before the cancellation of the qualified real property indebtedness. The basis of the depreciable real property is reduced by the excluded amount of COD income.

In many cases with the economic downturn of the real estate market, taxpayers have foreclosed on their home, sold their home in a short sale, or modified (restructured) their mortgage loans. Through December 31, 2012, taxpayers can exclude COD income up to $2 million ($1 million for married filing separate taxpayers) from taxable gross income, in whole or in part, of qualified principal residence indebtedness that is a result of a foreclosure, short sale (where the proceeds from the sale are insufficient to pay off the mortgage and the lender cancels the balance) or a loan modification.

In most cases, residential mortgage loans are considered recourse debt. A foreclosure involving recourse debt is treated as a deemed sale with the proceeds equal to the lesser of the secured debt or the FMV at the date of foreclosure. If the debt exceeds FMV, the difference is treated as COD income if it is forgiven. If the FMV exceeds the debt forgiven, the result is a gain on sale of the property and COD income, in this case only the portion of the transaction treated as COD income is available for the exclusion rule and the portion treated as a gain is not eligible.

If you find yourself involved in a transaction involving cancellation of debt, please contact your Dermody, Burke and Brown tax advisor to discuss how we can assist you with the potential tax consequences before beginning negotiations with your lender or as soon as possible afterward.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.