There has been a lot of discussion surrounding cancellation of debt income. Particularly with regard to the cancellation of debt with regard to Short Sales of Real Estate, Forclosures, and deeds in lieu of foreclosure. It is true that there are numberous exception to the taxation of cancellation of debt income. That is not the focus of this particular article. I have written articles that address this issue previously. The focus of this article is the tax attributes that must be adjusted due to not being taxed on the cancellation of debt income.
The government wanted to make sure that taxpayers did not receive an excessive benefit from not having to pay tax on cancellation of debt income. Therefore, certain attributes must be adjusted to compensate for this issue. They are reported on IRS Form 982.
According to the IRS, a taxpayer must do the following if a debtor excludes canceled debt from income because it was canceled in bankruptcy or during insolvency. The taxpayer
must use the excluded amount to reduce certain “tax attributes.”
Tax attributes include the basis of certain assets and the losses and
credits listed later. By reducing the tax attributes,
the tax on the canceled debt is partially
postponed instead of being entirely forgiven. This is what prevents an excessive
from the debt cancellation.
If a separate bankruptcy estate was created, the trustee or debtor-in-possession must reduce the estate's attributes (but
not below zero) by the canceled debt.
The IRS rules are as follows:
Order of reduction.
Generally, use the amount of canceled
debt to reduce the tax attributes in the order listed below. However,
may choose to use all or a part of the amount
of canceled debt to first reduce the basis of depreciable property
the other tax attributes. This choice is
Net operating loss.
Reduce any NOL for the tax year in
which the debt cancellation takes place, and any NOL carryover to that
General business credit carryovers.
Reduce any carryovers, to or from the
tax year of the debt cancellation, of amounts used to determine the
Minimum tax credit.
Reduce any minimum tax credit that is
available as of the beginning of the tax year following the tax year of
Reduce any net capital loss for the
tax year of the debt cancellation, and any capital loss carryover to
Reduce the basis of the debtor's property. This reduction applies to the basis of both depreciable and nondepreciable property.
Passive activity loss and credit carryovers.
Reduce any passive activity loss or
credit carryover from the tax year of the debt cancellation.
Foreign tax credit.
Last, reduce any carryover, to or
from the tax year of the debt cancellation, of an amount used to
determine the foreign
tax credit or the Puerto Rico and possession
Amount of reduction.
Except for the credit carryovers,
reduce the tax attributes listed earlier 1 dollar for each dollar of
that is excluded from income. Reduce the
credit carryovers by 33 cents for each dollar of canceled debt that is
Making the reduction.
Make the required reductions in tax
attributes after figuring the tax for the tax year of the debt
reducing NOLs and capital losses, first
reduce the loss for the tax year of the debt cancellation, and then any
to that year in the order of the tax years
from which the carryovers arose, starting with the earliest year. Make
of credit carryovers in the order in which
the carryovers are taken into account for the tax year of the debt
Individuals under chapter 7 or 11.
In an individual bankruptcy under
chapter 7 or 11 of title 11, the required reduction of tax attributes
must be made
to the attributes of the bankruptcy estate, a
separate taxable entity resulting from the filing of the case. Also,
of the bankruptcy estate must make the choice
of whether to reduce the basis of depreciable property first before
other tax attributes.