Debt Cancellation & Reduction

These are difficult economic times and many of my clients are having trouble paying all of their debts on a timely basis.  Some clients have been successful in negotiating a reduction or forgiveness of some debt obligations.  If you have been able to negotiate a settlement with one of your creditors, please be sure to let me know.  There may be tax consequences when debts are reduced or canceled.

Obviously, a reduction in debit will benefit the borrower by reducing a financial obligation and possibly freeing up incoming that was committed to debit retirement so that it can be used for other purposes.  However, as a general rule, taxable income includes the financial improvement from debt cancellation.  There are many exceptions to the rule but it is important to deal with and properly report debt cancellation.

One of the more important exceptions involves the cancellation of debt by private lenders, including friends or relatives.  If the debt cancellation is intended as a gift to the borrower, it is not considered to be part of the borrower’s gross income for tax purposes.  This exception would also apply to debt forgiveness in a Last Will and Testament or trust by a private lender upon the lenders death.

Some type of student loans include a provision that all or part of the debt will be forgiven if the borrower practices his or her profession in a low income or otherwise underserved area.  In the event that the borrower complies with the provisions of the loan agreement in exchange for reduction in the loan balance, that type of debt forgiveness is not taxable.

Another important exception applies when the debt canceled would otherwise be deductible on the borrower’s return if it had been paid.  One good example of this type of debt forgiveness would be the modification of a home loan to reduce accrued interest that could have been itemized as a deduction on the borrower’s tax return.

Finally, if there has been a later price adjustment by the seller of some property purchased by the borrower it does not produce income.  While the tax basis in the price reduced property would be decreased by the amount of the reduction, there is no taxable income.

In addition to the exceptions I have described, there are some statutory exclusions that may be important in characterizing any canceled debt that otherwise may constitute taxable income on your tax return.  The Internal Revenue Code provides for the following exception to the general rule that canceled debt must be included in taxable income:

  1. Debt discharged in bankruptcy;
  2. Debt discharged when taxpayer was insolvent;
  3. Qualified farm debt;
  4. Qualified real property business debt; and,
  5. Qualified personal residence debt.

With the high foreclosure rate in home loans, the qualified personal residence exclusion may frequently come into play.  It has some limitations but may apply when home loans are modified to prevent foreclosure or even when a home is lost to foreclosure.  The exclusions can be quite complicated and this letter is not the place to go over them in detail.

If you have debt canceled in full or in part by a bank or other financial institution, the lender is required to send the IRS a 1099-C reporting form.  You should receive a copy.  If you have moved or have changed your mailing address, be sure that you notify any banks or other lenders of your new address and do not forget to put in a change of address notice with the post office.  The IRS uses sophisticated computer matching software to identify and difference between the reports it receives from third parties and the information on your tax return.  If a 1099 is not properly dealt with on the tax return, an audit notice is very likely to be issued.

If you have debt that was forgiven in 2010, we can help you prevent inclusion of the canceled debt using all the exclusions and exceptions allowed by law.  If you receive an audit notice from the tax authorities due to a report of debt cancellation, we may be able to help you fix the problem even after the return has been filed.