How to correctly report forgiveness of debt for tax purposes

David Musser, Partner, Nichols Cauley & Associates LLC

With the decline in U.S. real estate markets and challenging economy, a large number of taxpayers continue to negotiate loan modifications to help relieve them of unmanageable debt. The issue of how to correctly report forgiveness of debt for tax purposes will be of importance for the next several years, as the volume of loans modified or canceled by lenders remains historically high, says David Musser, a partner at Nichols Cauley & Associates LLC.

Smart Business spoke with Musser about how to report forgiveness of debt.

How is debt treated for tax purposes?

If debt for which an individual taxpayer is personally liable is canceled or reduced in a loan modification arrangement, it can result in ordinary taxable income. In general, debt for which a taxpayer is personally liable is called recourse debt, while all other debt is nonrecourse.

For instance, in a foreclosure, when a taxpayer owns the property securing a recourse debt, the amount realized by the taxpayer when the property is disposed includes the unpaid amount of the debt, not just the fair market value (FMV) of the collateral. The amount of forgiven debt in excess of the property’s FMV may result in ordinary income in addition to the capital gain or loss measured by the difference between the FMV of the property and its adjusted basis.  If the taxpayer owned foreclosed property subject to nonrecourse debt in excess of the FMV, the foreclosure does not result in ordinary cancellation of debt income.  Instead, the amount of nonrecourse debt forgiven is treated as an amount realized upon disposition, and the capital gain or loss is measured by the difference between total amount realized and the adjusted basis of the property.

How is taxable canceled debt reported?

When debt is reduced or canceled, the lender typically sends Form 1099–C to the borrower. This form reports the lender’s and borrower’s name, address and taxpayer ID number, the amount and type of debt forgiven, the date of forgiveness, whether the taxpayer is personally liable for repayment, the FMV of foreclosed property that may be involved, interest that may be included in the amount of canceled debt and whether the canceled debt results from bankruptcy. Any taxable canceled debt must be reported as ordinary income on Form 1040, line 21 ‘Other Income,’ if the debt is nonbusiness debt.  In addition, nontaxable canceled debt and the resulting reduction of tax attributes must be reported on Form 982, ‘Reduction of Tax Attributes Due to Discharge of Indebtedness.’

Are there exceptions and exclusions?

Yes. For example, cancellation of debt resulting from a gift does not have to be included in taxable income, nor do student loans canceled or reduced as a result of complying with provisions in the loan agreement. Debt canceled in a Title 11 bankruptcy generally does not have to be included. Also excluded is canceled debt to the extent the taxpayer was insolvent.  A taxpayer can also elect to exclude income realized from the forgiveness of real property business indebtedness. Qualified real property business indebtedness is debt incurred or assumed in connection with real property used in a trade or business and secured by that real property. The amount of canceled qualified real property business debt a taxpayer can exclude is limited to the amount of outstanding principal immediately before the cancellation that is in excess of the fair market value of the real property securing the debt.  The excludable debt cannot be more than the total adjusted basis of depreciable real property held immediately before the cancellation. The calculation of the adjusted basis of the depreciable real property includes any reductions in basis required due to the exclusion of debt canceled under bankruptcy, insolvency, or farm indebtedness provisions.

What are the rules regarding home mortgage debt forgiveness?

With the Mortgage Forgiveness Debt Relief Act of 2007, a taxpayer can exclude income realized for the forgiveness of debt incurred to buy, build, or substantially improve a principal residence. This debt must be secured by the primary residence.

Debt used to refinance the home qualifies, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. This exclusion applies for qualified principal residence indebtedness forgiven in calendar years 2007 through 2012. The maximum amount that can be excluded is $2 million, or $1 million if married filing separately. The exclusion is claimed by checking box 1e of Form 982 and reporting the corresponding reduction of principal residence basis on Part II, line 10b. This exclusion applies only to forgiven debt realized in a disposition of principal residence, regardless of whether that disposition is the result of a foreclosure or short sale. It does not exclude any capital gain that may be realized. However, this capital gain may be excludable under I.R.C. Sec. 121 that allows a taxpayer to exclude up to $250,000 ($500,000 for joint filers) of capital gain from the sale or exchange of a home used as a principal residence for two of the preceding five years.

How do the rules impact state filings?

In most cases, Georgia conforms to the federal tax treatment of debt forgiveness. Therefore, any federal taxable income that includes or excludes debt cancellation income usually does not require an adjustment on the individual’s Georgia income tax return.

David Musser is a partner at Nichols Cauley & Associates LLC. Reach him at (404) 214-1301 or [email protected]

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