CANCELED DEBT - IS IT TAXABLE OR NOT?
IRS Publication #4681 covers Canceled Debts, Foreclosures, Repossessions, and Abandonments
There are two types of debts:
Lenders issue FORM 1099-C when a debt is canceled to both the IRS and to the borrower.
Recourse Debt: Borrower is personally liable for the debt
Holds the borrower personally liabile for the debt.
Holds the borrower personally liable for any amount not satisified by the surrender of secured property.
Allows the lender to collect what is owed for the debt even after they've taken any collateral.
There are two tax issues to consider: Canceled Debt Income and Gain or Loss on disposition of property
Canceled Debt Income: If a lender forecloses on property subject to a recourse debt and cancels the portion of the debt in excess of the Fair Market Value of the property, the canceled portion of the debt is treated as ordinary income from cancellation od indebtedness. This amount must be included in gross income UNLESS it qualifies for an exception or exclusion by IRS law.
Canceled debt income or excess debt amount ordinary income or canceled portion of debt ordinary income = Debt Balance - Fair Market Value of Property
Gain or Loss: In addition to this cancellation of indebtedness income, the taxpayer may realize a gain or loss on the disposition of property; this amount is generally the difference between the Fair Market Value of the property at the time of foreclosure and the taxpayer's adjusted basis
Gain or loss on disposition of property = Fair Market Value - Adjusted Basis
Nonrecourse Debt: Borrower is not personally liable for the debt
The borrower is not personally liable for the debt.
Does not allow the lender to pursue anything other than the collateral.
The debt is satisfied by the surrender of the secured property regardless of the Fair Market Value at the time of surrender.
There are two tax issues to consider: Canceled Debt income and Gain or Loss on disposition of property.
Canceled Debt Income: Not applicable. Nonrecourse debt is satisified by the surrender of the secured property regardless of the Fair Market Value at the time of surrender. The canceled portion of debt is not canceled debt income and is not taxable income.
Canceled Debt income or the canceled potrion of debt = none/not applicable
Gain or Loss: If the property that is subject to nonrecourse debt is abandoned, foreclosed upon, subject to a short sale, or repossessed by the lender, the circumstances are treated as a sale of the property. The amount realized or selling price is the balance of the debt at the time of disposition of the property; regardless of the Fair Market Value of the Property.
Gain or loss on disposition of property = Balance of debt at time of disposition of the property - Adjusted Basis.
Exceptions and Exclusions:
Some canceled or forgiven debt may be excluded from income by applying exceptions such as:
Gifts, bequests, devises, or inheritances
Certain student loans
Price reduced after purchase
There are several exclusions from the general rule for reporting canceled debt as income such as:
**Form 982 Reduction of Tax Attributes Due To Discharge of Indebtedness, must be filed with the taxpayer's return to show the amount of the canceled debt excluded: If you exclude canceled debt from oncome under one of the exclusions below, you must reduce certain tax attributes (usually basis of asset but there are are few others) but not below zero by the amounr of debt excluded.
Discharge of debt through Title 11 bankruptcy
Discharge of debt of (to the extent insolvent) taxpayer
Discharge of qualified farm indebtedness
Discharge of qualified real property business indebtedness
Discharge of qualified principal residence indebtedness
Note: Each of the above exclusions has sprcific rules and criteria which must be met
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