Cancellation of Debt Income

Section 108 allows taxpayers to exclude canceled debt from gross income under certain conditions. This guide explains how Section 108 works, who qualifies, and the tax consequences of canceled debt.

What is Cancellation of Debt Income?

Cancellation of Debt Income (CODI) occurs when a lender forgives or cancels part or all of a borrower's outstanding debt. Typically, this forgiven amount is considered income, which means it would normally be subject to income tax. However, IRC Section 108 provides specific exclusions that allow certain taxpayers to avoid including this income in their taxable income.

Why is Canceled Debt Treated as Income?

In general, the IRS views the cancellation of debt as a financial benefit to the borrower—similar to receiving cash. This is because when a debt is forgiven, the borrower no longer has to pay back that amount, effectively increasing their net worth. As a result, the IRS considers this amount as taxable income.

Key Exclusions Under IRC Section 108

IRC Section 108 outlines several scenarios under which canceled debt does not have to be reported as income. These exclusions are essential for taxpayers who may find themselves in difficult financial situations. Below are the primary exclusions:

1. Discharge in a Title 11 Case (Bankruptcy)

If a taxpayer has their debt discharged during a bankruptcy proceeding under Title 11 of the U.S. Code, they are allowed to exclude the canceled debt from their gross income. Bankruptcy is a legal way for individuals or businesses to seek relief from their debts when they cannot repay them.

2. Insolvency

A taxpayer may exclude canceled debt if they are insolvent at the time of the discharge. Insolvency means that a taxpayer's liabilities exceed their assets. The amount of the exclusion is limited to the amount of insolvency that the taxpayer experienced immediately before the debt was canceled.

Example of Insolvency

Imagine a taxpayer has $50,000 in assets and $80,000 in debts, making them $30,000 insolvent. If a lender forgives a $25,000 debt, the taxpayer can exclude that amount from their income since it falls within their insolvency limit.

3. Qualified Farm Indebtedness

Farmers who have debts related to their farming operations may also qualify for an exclusion under Section 108. This applies to debts that are canceled or forgiven, provided they meet specific criteria to be classified as "qualified farm indebtedness."

4. Qualified Real Property Business Indebtedness

This exclusion applies to taxpayers, except C corporations, who have debt related to real property used in their business. The debt must have been incurred in connection with the property, which is considered "qualified real property business indebtedness."

5. Qualified Principal Residence Indebtedness

Homeowners who have mortgage debt forgiven on their primary residence can also benefit from this exclusion. However, this exclusion applies only to debt discharged before January 1, 2026, or as part of an arrangement entered into before that date.

Coordination of Exclusions

Section 108 includes specific rules on how to coordinate multiple exclusions:

• Title 11 Exclusion Takes Precedence: If a debt is discharged in a bankruptcy case, the exclusion for bankruptcy takes priority over other exclusions.
• Insolvency Over Other Exclusions: If a taxpayer qualifies for both the insolvency exclusion and other business-related exclusions, the insolvency exclusion takes precedence.
• Principal Residence Over Insolvency: For a discharge related to a principal residence, this exclusion takes precedence over insolvency unless the taxpayer elects otherwise.

Impact on Tax Attributes

While taxpayers may exclude canceled debt from their income, they must also be aware that this exclusion can affect other tax attributes. Here’s how:

Reduction of Tax Attributes

When a taxpayer excludes canceled debt from their gross income, certain tax attributes may be reduced in a specific order, including:

1. Net Operating Losses (NOL): The amount of canceled debt will first reduce any net operating losses for the year of discharge.
2. General Business Credits: Any carryover of business credits will also be reduced.
3. Minimum Tax Credits: The credits available for the minimum tax will be adjusted.
4. Capital Loss Carryovers: Net capital losses and any carryovers will be affected.
5. Basis Reduction: The basis of the taxpayer's property may be reduced.
6. Passive Activity Losses and Credit Carryovers: Any losses or credits from passive activities will be adjusted.

Example of Tax Attribute Reduction

Suppose a taxpayer excludes $10,000 of canceled debt. They may have to reduce their net operating loss by that same amount. If they had a net operating loss of $15,000, it would now be $5,000.

Special Considerations for Real Property Business Indebtedness

Taxpayers who have qualified real property business indebtedness have additional considerations:

Basis Reduction

The exclusion amount related to qualified real property business indebtedness must reduce the basis of the taxpayer’s depreciable real property. This means that the taxpayer's basis in the property will be decreased, which can affect future depreciation deductions.

Limitations on the Exclusion

There are specific limitations on how much debt can be excluded under this category:

• The excluded amount cannot exceed the difference between the outstanding principal of the debt and the fair market value of the property at the time of the discharge.
• The total exclusion cannot exceed the adjusted basis of the depreciable real property held by the taxpayer immediately before the discharge.

How to Report Canceled Debt Income

If you qualify for exclusions under Section 108 and do not have to report the canceled debt as income, you must still properly document the transaction. Here are some steps:

1. Form 982: Taxpayers should use IRS Form 982 to report the discharge of indebtedness and claim any exclusions.
2. Keep Records: Maintain detailed records of the canceled debt, including the amount, the lender’s documentation of discharge, and any relevant financial statements.
3. Consult a Tax Professional: Since the rules can be complex, it may be beneficial to consult with a tax advisor, especially if you are dealing with significant amounts of canceled debt or multiple tax attributes.

Common Scenarios Involving Canceled Debt

Scenario 1: Personal Loans Forgiven

John took out a personal loan of $20,000. Due to unforeseen circumstances, he lost his job and was unable to repay the loan. His lender forgives the debt. John must determine if he is insolvent. If his liabilities exceed his assets, he can exclude the forgiven amount under the insolvency exclusion.

Scenario 2: Mortgage Forgiveness

Sarah owns a home and, due to economic hardship, received a $50,000 mortgage forgiveness from her lender. Since this forgiveness occurred before January 1, 2026, Sarah can exclude this amount from her income as qualified principal residence indebtedness.

Scenario 3: Business Debt Discharge

Mark runs a small business and has a loan of $100,000 secured by his commercial property. When the property value dropped significantly, he was unable to repay the loan, and the lender discharged $70,000 of the debt. Mark qualifies for the exclusion for qualified real property business indebtedness. This means he does not have to report the $70,000 as income, but it will reduce the basis of his property.

Conclusion

Understanding the implications of canceled debt is important for taxpayers who may face financial difficulties. Section 108 offers exclusions that can prevent taxpayers from facing a significant tax burden due to forgiven debts. However, these rules can be complex, particularly concerning the reduction of tax attributes and the coordination of exclusions. Taxpayers should carefully assess their financial situations and consider seeking professional tax advice to ensure compliance and maximize potential benefits.

By being informed about the provisions of IRC Section 108, taxpayers can make educated decisions regarding their finances and avoid unnecessary tax liabilities related to canceled debt income.