March 2010

Forgiveness of Debt and Bankruptcy
By Angela L. Bursby, CPA

            Due to the “recession” and these tough economic times, more borrowers are having debt cancelled or forgiven and/or filing bankruptcy as a consequence. What those borrowers may not have realized is that the amount of debt that is cancelled or forgiven may have tax consequences.

            The tax laws state that “discharge of indebtedness” should be included as income unless an exception or exclusion applies. One exception applies to certain student loans where the borrower agrees to work in certain rural or low income areas in exchange for cancellation of their loans. Another exception applies when the lender is a relative or friend who intends to cancel the debt as a gift.

            An important exclusion from this law is directed at those who have lost their homes. Forgiven or cancelled mortgage debt is not taxable as long as it is for a primary residence. This applies to restructuring of mortgage debt, foreclosure, and short sales (where the sales proceeds are not enough to pay off the mortgage and the lender cancels the balance). This law is in effect through 2012.

            Any debts discharged through bankruptcy are not considered taxable income. Also, if you can show that you are insolvent at the time of the cancellation of debt, it is excluded from income. If a debt is incurred directly in the operation of a farm, more than half your income from the prior three years was from farming, and the loan is from someone regularly engaged in lending, the cancellation of that debt can be excluded from taxable income also.

            The lender is required to send a 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount on 1099-C will be included as ordinary income unless an exception or exclusion applies. If an exclusion applies, it will be reported on Form 982, Reduction of Tax Attributes due to Discharge of Indebtedness, and attached to your tax return.

            Please contact Knueven, Schroeder & Co. if you would like more information about cancellation or forgiveness of debt and the tax consequences associated with that debt.