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Taxmap/pubs/p908-004.htm#TXMP2914288c Debt Cancellation

Canceled Debt

If a debt is canceled or forgiven, other than as a gift or bequest, the debtor generally must include the canceled amount in gross income for tax purposes. A debt includes any indebtedness for which the debtor is liable or which attaches to property the debtor holds.

Taxmap/pubs/p908-004.htm#TXMP109444ef Exceptions and Exclusions

There are several exceptions and exclusions from the inclusion of canceled debt in income. The exceptions include:

1. The cancellation of a student loan for a student required to work for certain employers. See Cancellation of student loan in Publication 525, Taxable and Nontaxable Income.
2. The cancellation of debt that would have been deductible if paid.
3. The reduction of a debt by the seller of property if the debt arose from the purchase of the property.

The exclusions are discussed next.

Taxmap/pubs/p908-004.htm#TXMP3364f4e9 Exclusions

Exclusion

Do not include a canceled debt in gross income if any of the following situations apply:

• The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.
• The cancellation takes place when you are insolventp0908 insolvency(see Insolvency exclusion, later), and the amount excluded is not more than the amount by which you are insolvent.
• The canceled debt is qualified farm debt (debt incurred in operating a farm). See Chapter 4 of Publication 225, Farmer's Tax Guide.
• The canceled debt is qualified real property business indebtedness (certain debt connected with business real property). See Publication 525, Taxable and Nontaxable Income.

Taxmap/pubs/p908-004.htm#TXMP53fed8cc Order of exclusions.

If the cancellation of debt occurs in a title 11 bankruptcy case, the bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, or qualified real property business indebtedness exclusions.

To the extent that the taxpayer is insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions.

Taxmap/pubs/p908-004.htm#TXMP7ff0eb2c Bankruptcy case exclusion.

A bankruptcy case is a case under title 11 of the United States Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.

None of the debt canceled in a bankruptcy case is included in your gross income in the year canceled. Instead, certain losses, credits, and basis of property must be reduced by the amount of excluded income (but not below zero). These losses, credits, and basis in property are called tax attributes and are discussed under Reduction of Tax Attributes, later. p0908 insolvency

Taxmap/pubs/p908-004.htm#TXMP7222eea2 Insolvency exclusion.

You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.

Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained laterp0908 reduction of tax attributesunder Reduction of Tax Attributes.

Taxmap/pubs/p908-004.htm#TXMP1f673a44
Example.

$4,000 of the Simpson Corporation's liabilities are cancelled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation's liabilities totaled $21,000 and the fair market value of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 − $17,500).

The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.

Taxmap/pubs/p908-004.htm#TXMP2cbf064a Reduction of   Tax Attributes

Reduction of Tax Attributes

If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain "tax attributes." Tax attributes include the basis of certain assets and the losses and credits listed next. By reducing these tax attributes, tax on the canceled debt is in part postponed instead of being entirely forgiven. This 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. See Individuals under chapter 7 or chapter 11, later.

Taxmap/pubs/p908-004.htm#TXMP5f4004b1 Order of reduction.

Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below. However, you 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 discussedp0908 election to reduce basis firstlater.

Taxmap/pubs/p908-004.htm#TXMP2575ef79 Net operating loss.

First, reduce any net operating loss for the tax year in which the debt cancellation takes place, and any net operating loss carryover to that tax year.

Taxmap/pubs/p908-004.htm#TXMP6166514e General business credit carryovers.

Second, reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit.

Taxmap/pubs/p908-004.htm#TXMP42a61af0 Minimum tax credit.

Third, reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation.

Taxmap/pubs/p908-004.htm#TXMP3b31d277 Capital losses.

Fourth, reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.

Taxmap/pubs/p908-004.htm#TXMP4898bb1f Basis.

Fifth, reduce the basis of your property as describedp0908 basis reductionunder Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property.

Taxmap/pubs/p908-004.htm#TXMP4d054b30 Passive activity loss and credit carryovers.

Sixth, reduce any passive activity loss or credit carryover from the tax year of the debt cancellation.

Taxmap/pubs/p908-004.htm#TXMP732ceecf 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.

Taxmap/pubs/p908-004.htm#TXMP55055378 Amount of reduction.

Except for the credit carryovers, reduce the tax attributes listed earlier one dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 331/3 cents for each dollar of canceled debt that is excluded from income.

Taxmap/pubs/p908-004.htm#TXMP305bd104 Making the reduction.

Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing net operating losses 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.

Taxmap/pubs/p908-004.htm#TXMP250d5fcd Individuals under chapter 7 or chapter 11.

In an individual bankruptcy under chapter 7 (liquidation) or chapter 11 (reorganization) 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. See the discussion of The Bankruptcy Estate, earlier. p0908 basis reduction

Taxmap/pubs/p908-004.htm#TXMP15e9ee8d Basis Reduction

Basis Reduction

If any amount of the debt cancellation is used to reduce the basis of assets as discussedp0908 reduction of tax attributesunder Reduction of Tax Attributes, the following rules apply to the extent indicated.

Taxmap/pubs/p908-004.htm#TXMP7e0e8ae9 When to make the basis reduction.

Make the reduction in basis at the beginning of the tax year following the tax year of the debt cancellation. The reduction applies to property held at that time. See section 1.1017–1 of the Income Tax Regulations for more information.

Taxmap/pubs/p908-004.htm#TXMP57d2b6fc Bankruptcy and insolvency reduction limit.

The reduction in basis because of canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussedp0908 election to reduce basis firstlater.

Taxmap/pubs/p908-004.htm#TXMP008cbed8 Exempt property under title 11.

If debt is canceled in a bankruptcy case under title 11 of the United States Code, make no reduction in basis for property that the debtor treats as exempt property under section 522 of title 11.

Taxmap/pubs/p908-004.htm#TXMP17c42948 Election to reduce basis first.

You (the estate in the case of an individual bankruptcy under chapter 7 or 11) may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.

Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. You may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. You must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, you can only revoke it with IRS approval. However, if you establish reasonable cause, you may make the choice with an amended return or claim for refund or credit.

Taxmap/pubs/p908-004.htm#TXMP6c2b5513 Making elections.

Make the election to reduce the basis of depreciable property before reducing other tax attributes as well as the election to treat real property inventory as depreciable property, on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

Taxmap/pubs/p908-004.htm#TXMP778c335b Recapture of basis reductions.

If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain that is from this basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of this basis reduction as a depreciation deduction and by treating any such basis-reduced property that is not already either section 1245 or section 1250 property as section 1245 property. In the case of section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation. Sections 1245 and 1250 and the recapture of gain as ordinary income are explainedp0544 disposition depreciable propertyin Chapter 4, Dispositions of Depreciable Property, in Publication 544, Sales and Other Dispositions of Assets.

Taxmap/pubs/p908-004.htm#TXMP7ac8bccf Partnerships

Partnership

If a partnership's debt is canceled because of bankruptcy or insolvency, the rules for the exclusion of the canceled amount from gross income and for tax attribute reduction are applied at the individual partner level. Thus, each partner's share of debt cancellation income must be reported on the partner's return unless the partner meets the bankruptcy or insolvency exclusions explained earlier. Then all choices, such as the choices to reduce the basis of depreciable property before reducing other tax attributes, to treat real property inventory as depreciable property, and to end the tax year on the day before filing the bankruptcy case, must be made by the individual partners, not the partnership.

Taxmap/pubs/p908-004.htm#TXMP068c3370 Depreciable property.

For purposes of reducing the basis of depreciable property in attribute reduction, a partner treats his or her partnership interest as depreciable property to the extent of the partner's proportionate interest in the partnership's depreciable property. This applies only if the partnership makes a corresponding reduction in the partnership's basis in its depreciable property with respect to the partner.

Taxmap/pubs/p908-004.htm#TXMP44b4a491 Partner's basis in partnership.

The allocation of an amount of debt cancellation income to a partner results in that partner's basis in the partnership being increased by that amount. At the same time, the reduction in the partner's share of partnership liabilities caused by the debt cancellation results in a deemed distribution, in turn resulting in a reduction of the partner's basis in the partnership. These basis adjustments are separate from any basis reduction under the attribute-reduction rules describedp0908 reduction of tax attributesearlier.

Taxmap/pubs/p908-004.htm#TXMP65dca5a6 Corporations

Corporation

Corporations in a bankruptcy proceeding or insolvency generally follow the same rules for debt cancellation and reduction of tax attributes as an individual or individual bankruptcy estate would follow.

Taxmap/pubs/p908-004.htm#TXMP00bf4b72 Stock for Debt Exchange

Stock for Debt Exchange

If a corporation transfers its stock in satisfaction of indebtedness and the fair market value of its stock is less than the indebtedness it owes, the corporation has income (to the extent of the difference) from the cancellation of indebtedness. After 1994, a corporation can exclude all or a portion of the income created by the stock for debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent. However, the corporation must reduce its tax attributes (to the extent it has any) by the amount of excluded income.

Taxmap/pubs/p908-004.htm#TXMP595f6b81 Stock for debt exception.

The stock for debt exception was repealed for transfers made after 1994 unless the corporation filed for bankruptcy (or similar court proceeding) before 1994. Generally, before 1995, a corporation did not realize income because of such stock for debt exchanges if it was in bankruptcy or to the extent it was insolvent. Consequently, there was no gross income to exclude and no reduction of its tax attributes was necessary. The principal difference between the stock for debt exception and the stock for debt exchange is that the corporation does not reduce its tax attributes under the stock for debt exception.

Taxmap/pubs/p908-004.htm#TXMP6b92609f Earnings and profits

Earnings and profits

The earnings and profits of a corporation do not include income from the discharge of indebtedness to the extent of the amount applied to reduce the basis of the corporation's property as explainedp0908 basis reductionearlier. Otherwise, discharge of indebtedness income, including amounts excluded from gross income, increases the earnings and profits of the corporation (or reduces a deficit in earnings and profits).

If there is a deficit in the corporation's earnings and profits and the interest of any shareholder of the corporation is terminated or extinguished in a title 11 or similar case (defined earlier), the deficit must be reduced by an amount equal to the paid-in capital allocable to the shareholder's terminated or extinguished interest.

Taxmap/pubs/p908-004.htm#TXMP3cfbbc9b S Corporations

S Corporation

For S corporations, the rules for excluding income from debt cancellation because of bankruptcy or insolvency apply at the corporate level.

Taxmap/pubs/p908-004.htm#TXMP73586cba Net operating losses.

A loss or deduction that is disallowed for the tax year of the debt cancellation because it exceeds the shareholders' basis in the corporation's stock and debt is treated as a net operating loss for that tax year in making the required reduction of tax attributes for the amount of the canceled debt.

Taxmap/pubs/p908-004.htm#TXMP5aaac759 Example of   Tax Attribute Reduction

The sample filled-in Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), shown in this publication is based on the following situation.

Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 1995, he reached an agreement with his creditors, whereby they agreed to forgive $10,000 of the total that he owed them, in return for his setting up a schedule for repayment of the rest of his debts.

Immediately before the debt cancellation, Tom's liabilities totaled $120,000 and the fair market value of his assets was $100,000 (his total basis in all these assets was $90,000). At the time of the debt cancellation, he was considered insolvent by $20,000. He can exclude from income the entire $10,000 debt cancellation because it was not more than the amount by which he was insolvent.

Among Tom's assets, the only depreciable asset is a rental condominium with an adjusted basis of $50,000. Of this, $10,000 is allocable to the land, leaving a depreciable basis of $40,000. He has a long-term capital loss carryover to 1996 of $5,000. He also has a net operating loss of $2,000 and a $3,000 net operating loss carryover from 1994. He has no other tax attributes arising from the current tax year or carried to this year.

Ordinarily, in applying the $10,000 debt cancellation amount to reduce tax attributes, Tom would first reduce his $2,000 net operating loss, next his $3,000 net operating loss carryover from 1994, and then his $5,000 net capital loss carryover. However, he figures that it is better for him to preserve his loss carryovers for the next tax year.

Tom elects to reduce basis first. He can reduce the depreciable basis of his rental condominium (his only depreciable asset) by $10,000. The tax effect of doing this will be to reduce his depreciation deductions for years following the year of the debt cancellation. However, if he later sells the condominium at a gain, the part of the gain from the basis reduction will be taxable as ordinary income.

Tom must file Form 982, as shown here, with his individual return (Form 1040) for the tax year of the debt discharge. In addition, he must attach a statement describing the debt cancellation transaction and identifying the property to which the basis reduction applies. This statement is not illustrated.

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