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 insolvent (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.
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.
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.
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 later under Reduction of Tax Attributes.
Example.
$4000 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.
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.
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 discussed later.
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.
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.
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.
Capital losses. Fourth, reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.
Basis. Fifth, reduce the basis of your property as described under Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property.
Passive activity loss and credit carryovers. Sixth, reduce any passive activity loss or credit carryover from the tax year of the debt cancellaton.
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 one dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 33⅓ 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 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.
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.
Information courtesy of the Internal Revenue Service.
