Practitioners should be mindful that both debts from commercial lenders and private lenders are subject to tax unless an exception or exclusion applies. For example, absent an exception or exclusion, forgiven credit card or mortgage debt from a bank is subject to tax. Likewise, a loan forgiven by one’s uncle technically is subject to tax.

Exceptions. There are these exceptions to the general rule that debt forgiveness triggers income:

•    No income arises if the forgiveness is a gift or if it is a bequest under a will. The gift exception is not available for a commercial loan.
•    Certain forgiven student loans are not subject to tax (e.g., doctors, nurses and teachers serving in rural or low income areas).
•    There is no income from cancellation of deductible debt. For example, if a lender cancels home mortgage interest that could have been claimed as an itemized deduction on Schedule A of Form 1040, there is no income.
•    No income arises from a subsequent purchase price reduction after the fact. Here, the reduced price is not income but lowers the purchaser’s basis in the property.

Exclusions.  Debt cancellation income may escape tax under one or more of the following exclusions.

•    Discharge of debt in bankruptcy.
•    Discharge of debt of insolvent taxpayer.
•    Discharge of qualified farm debt.
•    Discharge of qualified real property business debt.
•    Discharge of qualified principal residence debt.

Practitioners should realize that these exclusions are quite complex and require reduction’s in the client’s tax attributes. They also can be tricky to apply in certain cases. For example, the insolvency exclusion applies if the client’s total debts exceed the total fair market value of the clients’ assets including pension and other retirement accounts. Figuring out the client’s total debts may not be too onerous but figuring out the fair market value of each and every asset the client owns can be quite cumbersome.

Residence exclusion. Practitioners may find that many distressed homeowners may wish to avail themselves of the exclusion for discharge of qualified principal residence debt. This exclusion applies where a taxpayer restructures his acquisition debt on a principal residence, loses his principal residence in a foreclosure, or sells a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance.)

Taxpayers generally may exclude up to $2 million of mortgage debt forgiveness on their principal residence. Specifically, gross income doesn't include any discharge of qualified principal residence indebtedness—i.e., acquisition indebtedness under Code Sec. 163(h)(3)(B) with respect to the taxpayer’s principal residence, but with a $2 million limit ($1 million for married individuals filing separately).

“Principal residence” has the same meaning as under the homesale exclusion rules of Code Sec. 121 . Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing doesn't exceed the amount of the refinanced indebtedness.

It is important to remember that debt forgiven on a second home doesn’t’ qualify for this exclusion. Nor can it be used to shield forgiven home equity debt.

Reporting. There are certain types of forgiven debt that aren’t taxable, but must be reported. These include debts qualifying for the foregoing exclusions. They must be reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

Recent law changes. Practitioners should be mindful of these recent law changes in this area.

•    The Emergency Economic Stabilization Act of 2008 allows qualified individuals to exclude from gross income discharges of nonbusiness indebtedness canceled by an applicable entity because of Midwestern disasters. The exclusion only applies to cancellations made on or after the applicable disaster date and before 2010.
•    A provision in the American Recovery and Reinvestment Act of 2009 allows taxpayer to elect to recognize a canceled business debt in income over a 5-year period.

Communicating with clients. Practitioners should ask their clients if they have received any Forms 1099-C.  A client should receive a Form 1099-C from a federal government agency, financial institution, or credit union that forgave a debt of $600 or more. The amount of the canceled debt is shown in box 2.  Any forgiven interest included in the amount of canceled debt in box 2 will also be shown in box 3. 

A Form 1099-C may contain one or more mistakes that if corrected may result in big tax savings in certain situations. It may be for the wrong year or the amount may have been previously reported. It may show a higher taxable amount that in fact was the case. In these situations, inform the client to contact the lender in writing and request it to issue a corrected Form 1099-C showing the proper amount of canceled debt.

If a lender won’t correct a Form 1099-C, be sure to include an explanation if a lesser amount of canceled debt is reported on Form 1040, line 21 (other income) than is shown on the Form 1099-C.