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 tax benefit 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, the debtor may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. This choice is discussed later.
Net operating loss.   Reduce any NOL for the tax year in which the debt cancellation takes place, and any NOL carryover to that tax year.
General business credit carryovers.   Reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit.
Minimum tax credit.   Reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation.
Capital losses.   Reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.
Basis.   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 tax credit.
Amount of reduction.   Except for the credit carryovers, reduce the tax attributes listed earlier 1 dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 33 cents for each dollar of canceled debt that is excluded from income.
Making the reduction.   Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing NOLs and capital losses, first reduce the loss for the tax year of the debt cancellation, and then any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. Make the reductions of credit carryovers in the order in which the carryovers are taken into account for the tax year of the debt cancellation.
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, the trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes.