Exceptions to the Taxability of Cancellation of Indebtedness Income
Under well established income tax principles, when a borrower receives loan proceeds he or she does not include the amount in gross income because of the corresponding obligation to repay the loan. However, if the lender subsequently cancels or forgives the loan, the amount of the forgiven liability must be included in the borrower's gross income and is subject to tax. This amount is referred to as cancellation of indebtedness income, or COD income. The Internal Revenue Code (I.R.C) provides several exceptions to the general rule that COD income is taxable.
Two of these exceptions, referred to as the bankruptcy and insolvency exceptions, reflect Congress' intent to aid taxpayers who are suffering financially. COD income arising out of a Title 11 bankruptcy case is excluded from gross income. This exception promotes the "fresh start" concept that bankruptcies seek to achieve. The insolvency exception provides that a taxpayer may exclude COD income if he or she is insolvent immediately before the cancellation of debt. However, the excluded amount of COD income is limited to the amount by which the taxpayer is insolvent. Insolvency is defined as the excess of the taxpayer's liabilities over the fair market value of assets. For example, if Taxpayer A has assets with a fair market value totaling $100 and liabilities totaling $150 he is insolvent by $50. If he receives debt relief of $30 he would be able to exclude the entire $30 from gross income. However, if he receives debt relief of $80, he would only be able to exclude $50, the amount by which he is insolvent. The difference of $30 would be included as ordinary income to the taxpayer.
Another exception, known as the Purchase Price Reduction, provides that apurchaser ofproperty does not realize COD income when he or she and the original seller agree to reduce a debt obligation. However, this exception does not apply if the debt has been transferred to a third party, if the reduction occurred in a Title 11 bankruptcy case, or if the purchaser was insolvent. For example, assume Taxpayer A purchases Whiteacre for $100 from B, who also provides mortgage financing. If, a few months later, A and B agree to reduce the outstanding debt to $80, the $20 will be considered a purchase price reduction and A will not realize COD income from the transaction. However, if after the initial sale, B sells the mortgage note to C, who later reduces the outstanding debt to $80, barring another exception, A will incur COD income of $20 because C is not the original seller.
Non-corporate taxpayers may defer recognizing COD income upon the cancellation of "qualified real property business indebtedness" exception. If a taxpayer chooses to apply this provision, he or she must reduce the basis in the qualified business property by the amount of the cancelled debt, thus creating a deferral of income. The policy behind this exception is to assist financially troubled taxpayers by deferring the inclusion of taxable income to a period when taxpayers are financially able to pay the tax liability. However, a taxpayer can only defer the amount by which the outstanding principal of the debt prior to the cancellation exceeds the fair market value of the encumbered business property. For example, assume Taxpayer A owns depreciable business property with a fair market value of $30,000 that is encumbered by a $50,000 debt. If the lender forgives the $50,000 debt, A can only exclude $20,000 of COD income, representing the difference between the debt and the fair market value. A would be required to reduce the basis in the property by $20,000 and recognize the remaining $30,000 of COD income unless another exception applies. Another limitation stipulates that the exclusion amount cannot exceed the aggregate basis of depreciable real property held by the taxpayer immediately prior to the cancellation. Additionally, if the taxpayer is insolvent, the insolvency exception applies first.
Perhaps the most widely known exception to the rule that COD income is taxable is the "qualified principal residence indebtedness" ("QPRI") exception, which Congress enacted in 2007. QPRI includes debt that a taxpayer incurred to purchase, build, or substantially improve a principal residence. If the taxpayer uses loan proceeds for other purposes, such as purchasing a vehicle, the proceeds will not be considered QPRI and cannot be excluded under this exception. For example, assume Taxpayer A's principal residence is secured by a mortgage note of $200,000. Further assume that A used $20,000 of the loan proceeds to purchase a personal vehicle. If the lender later forgives the $200,000 debt, only $180,000 would be eligible for the exclusion. The taxpayer bears the burden of proof for exclusion of COD income. Therefore, the taxpayer must be able to substantiate with proper documentation that the loan proceeds were actually used to purchase, build, or improve his or her principal residence.
Generally, a taxpayer's principal residence is the place where the taxpayer lives a majority of the time but is ultimately determined upon all the facts and circumstances. A taxpayer can only have one principal residence at any one time. Accordingly, cancelled debt on second homes, vacation homes, and business or investment property cannot be excluded under this exception. Discharged credit card debt is also not eligible to be excluded.
A refinanced mortgage on a principal residence qualifies up to the amount of the old mortgage principal prior to the refinancing. Additionally, taxpayers granted debt relief in foreclosure proceedings and mortgage restructuring transactions are eligible for the income exclusion. However, taxpayers only qualify for the exclusion if the discharge was related to the decline of the value of the principal residence or the taxpayer's financial situation. Therefore, a taxpayer who performs services for the lender in exchange for cancelled debt cannot exclude the discharged amount from gross income. The exclusion is also not available to taxpayers in Title 11 bankruptcy proceedings. An insolvent taxpayer has the option of utilizing the insolvency exclusion or the QPRI exclusion. The insolvency exception would provide a better alternative to a taxpayer with consumer debt mortgage, which would not qualify under the QPRI exclusion.
Taxpayers who want to take advantage of the QPRI exclusion must act fast because it is set to expire at the end of 2012.