Generally speaking if you owe a debt to someone else and they cancel that debt or they forgive that debt, the cancellation of debt becomes for tax purposesINCOME: That amount of the cancellation of debt needs to be reported as ordinary income on an appropriate tax return for that time period. HOWEVER because of certain exceptions provided by law you may not have to report that canceled debt as income if it qualifies under the exceptions.
BANKRUPTCY: A debt canceled in a bankruptcy case i.e. a Chapter 7, that debt would not be reportable as income and a special form called a 982 has to be attached to your Federal income tax showing the cancellation was due to a bankruptcy and not reportable income.
INSOLVENCY: If it is proved that you were insolvent immediately before the cancellation of debt then that debt is not reportable income. You are insolvent if to the extent that the total of all your liabilities exceed the fair market value of all your assets.
QUALIFIED REAL PROPERTY INDEBTEDNESS: You can elect to exclude canceled qualified real property business indebted from income if that debt meets all of the following: number one it is incurred or assumed with connection with real property used in a trade of business; number two if it is secured by such real property or number three if it is incurred or assumed either before 1993 or after 1992 meeting certain other conditions.
QUALIFIED PRINCIPAL RESIDENCE INDEBTNESS: You can exclude cancellation of debt if it is qualified principal residence. That indebtedness is any debt occurred in acquiring, constructing or substantially improving your principal residence in which is secured by your principal residence. The definition of your principal residence is a home where you ordinary live most of the time. There are many individuals that are under false impression that all dollar amounts that are connected to qualified residents will be extinguished as an exception for the cancellation of debt. Qualified Residence Indebtedness includes any debts that include the principal residents resulting from the refinancing of the debt incurred to require, construct or substantially improve the business residence BUT only to the extent that the amount of debt does not exceed the amount of the refinance debt.
FORECLOSURES AND REPOSESSIONS: If you default on the payments for a loan that you have which is secured by your property then the lending institution may foreclose on that loan and or repossess the property. The foreclosure or the repossession is treated as a form of a sale, which you may realize gain or loss. This is true even if you voluntary return the property to the lender. If the outstanding loan balance is more than the fair market value of the property and the lender cancels or part of the remaining loan balance you may realize ordinary income from the cancellation of debt.
This is a brief review of a very complicated area, which needs to be analyzed by anyone who is in business or has credit card cancellation, or foreclosures on personal and business property. Additionally the cancellation of debt for a personal residence is not as cut and dried as one would think. If you have any of these situations as outlined in this article make absolutely sure that your tax preparer when addressing these issues for the appropriate tax year understands all the ins and outs of all the laws connected with the cancellation of debt, the exceptions and the exclusions, and the adjustments that have to be made for reduction of tax attributes.
Article provided to the La Quinta Chamber of Commerce – GEM Publication November 2008 page 20.
http://www.lqchamber.com/pdf/gem-nov08.pdf
