As we indicated in the discussion in Part 1, the Internal Revenue Code has provisions under which part or all of cancellation of Debt (COD) may not be taxable.  There are five situations that allow you to exclude COD from taxation.

1.  Discharge of indebtedness in bankruptcy under title 11.

2.  Discharge of indebtedness to the extent you are insolvent (not in a title 11 case).  You are insolvent if your liabilities (including the discharged debt) exceed the fair market value of your assets at the date of the discharge.

3.  Discharge of qualified farm indebtedness.

4.  Discharge of qualified real property business indebtedness.  Typically this would be rental property that you report on Schedule E or C.  This may be limited by certain tax attributes as discussed below.

5.  Discharge of qualified principal residence indebtedness.  You can only have one principal residence.  The maximum exclusion is $2,000,000 on a joint return and $1,000,000 on a single return through 12/31/12.  Effective 1/1/13 the limits revert back to $1,000,000 and $500,000.  The only debt allowed is for the cost of the original purchase of the home and the cost of improvements to the home.  Home equity loan proceeds use for any other purpose would not qualify.

If you utilize any of these exclusions you must reduce tax attributes.  There are a number of tax attributes, but the most common are:

  • Future depreciation, as your basis would be reduced
  • Net operating loss carry forwards
  •  Capital loss carry forwards

You may not have any of these tax attributes or the discharge is greater than your attributes.  In either case, the excess excluded COD is still not subject to tax and goes away in the year of the COD.

So, if you think you might be eligible for one of the exclusions for your COD mentioned above, please contact us.  You will need to attach Form 982 to your return for the year of that the COD occurs.  The form is rather technical and we will assist you in the preparation of the form.

What if the COD happens in a partnership or S corporation?  We will discuss how to handle that situation in Part 3.