Cancellation of Debt

[GTS1101]

This may be a stupid question but I was wondering if others have thought about this. In pub 908 it says that there are several exceptions and exclusions from the inclusion of canceled debt as taxable income. One of the exceptions says that the cancellation of debt income does not have to be included if it would have been deductible if paid. What does that mean? It sounds to me like cancellation of a mortgage debt whether recourse or non-recourse is not included because a mortgage debt would have been deductible if it was continued to be paid and not canceled. I know that is not the case though because the IRS has clear instructions on how to apply the law to foreclosures and short sales for cancellation of debt. So if this does not apply to mortgages what kind of debt forgiven would have been deductible if paid? I know credit card debt is not. Auto Loan debt is not. Maybe student loan debt? Anybody else have any thoughts on this. This cancellation of debt stuff is real tricky but at the same time it is challenging and keeps the mind fresh. Appreciate any insight anyone can offer.

GTS1101

[Jesse]

Just thinking out loud...........

Did not research, but I think it is cancellation of debt related business expense. If you add income in the same amount you would deduct the expense it would still wash out to zero, so you cannot take the expense you did not pay, and you do not include the cancelled debt as income?

[Gretel]

Yup, this is what came to my mind. However, let's say credit card debt of $5,000 was forgiven, the expense was taken already when incurred, maybe years ago, so now what? It still would be income.

So, I don't really know what debt that could be.

[SueBaby]

Yup, this is what came to my mind. However, let's say credit card debt of $5,000 was forgiven, the expense was taken already when incurred, maybe years ago, so now what? It still would be income.

So, I don't really know what debt that could be.

I have a client that has $16,000 in credit cards was forgiven. When I called the IRS on it they said to add all the assets up and liabilites. Subtract the liabilites from assets and that number subtract from the $16,000 and that number goes toward income. Well, their liabilites are higher than assets so does the whole $16,000 goes on income?

[Gretel]

If liabilities are higher than assets (including home and retirement accounts if individual) then client is insolvent and COD income is not taxable.

[Earl]

Cancelled Debt

Cancelled debt as shown on 1099-C normally does not include interest (only the amount of balance forgiven) so there would be no deductible amount as you were suggesting. If interest is included in the forgiven debt it will be shown in box 3 and if normally a deductible interest (such as mortgage interest on residence) it would not be included in income as cancelled debt.

[David1980]

If insolvent you can exclude cancellation of debt to the extent of the insolvency. So if $10,000 was canceled and reported on 1099-C, total assets are $105,000 and total liabilities are $110,000 they are insolvent by $5,000 and can reduce the $10,000 of the debt canceled by $5,000. The other $5,000 would be included in income.

TTB deluxe 14-10 has an example.

As far as it being deductible as paid, I always took that to mean for example the interest accrued on a home. If the interest was reported as canceled debt you would exclude that portion because it would have been deductible had the taxpayer paid it.

"It sounds to me like cancellation of a mortgage debt whether recourse or non-recourse is not included because a mortgage debt would have been deductible if it was continued to be paid and not canceled. "

Not quite, because only the interest is deductible and not the total mortgage payment.