A common exclusion of “debt cancellation income” from taxable income results if the taxpayer was insolvent in the year that the debt was cancelled. “Insolvent” means that the taxpayer’s liabilities exceed the fair market value of the assets.1  This is a common option for removing cancelled debt income as many creditors only cancel debt after determining that the taxpayer is insolvent. Obtain a copy of the taxpayer’s credit report for that taxable year, which should list all the taxpayer’s debts.

Income in excess of insolvency is includible in a partially insolvent taxpayer’s income.2  The insolvency exclusion won’t apply to a discharged debt to which the § 108(a)(1)(E) exclusion for “qualified principal residence indebtedness” applies unless the taxpayer elects the § 108(a)(1)(B) insolvency exclusion. Cancellation of a debt that would have been deductible if paid, e.g., mortgage interest, is excluded from income.3

In Carlson v. Commissioner, the Tax Court has held that exempt assets, e.g., a homestead exemption for the family home, must be included in determining whether a taxpayer is “insolvent.”4  Some consideration should be given to challenging Carlson since it has been criticized.

Another issue is whether a separated spouse’s assets must be included in the insolvency analysis. Prior to Carlson, the IRS had issued a private letter ruling that a spouse’s separate assets should not be considered in determining whether the other spouse is insolvent for the purposes of the § 108 exclusion.5

• 1I.R.C. § 108(d)(3).
• 2I.R.C. § 108(a)(3).
• 3I.R.C. § 108(e)(2).
• 4Carlson v. Comm’r, 116 T.C. 87 (2001).
• 5Priv. Ltr. Rul. 8920019 (Feb. 14, 1989).

Debts that are discharged as part of a court-approved bankruptcy should not be reported as taxable cancelled debt income, but some creditors mistakenly do so. The tax attorney should include a copy of the Discharge Order from the bankruptcy court when filing the return or during an examination. The bankruptcy exclusion will not apply if the taxpayer fails to obtain a bankruptcy discharge granted by the bankruptcy court or under a plan approved by the bankruptcy court.1  Make sure that the bankruptcy resulted in a discharge and not a dismissal.

• 1See I.R.C. § 108(C)(2); Hill v. Comm’r, T.C. Memo 2009-101; Schachner v. Comm’r, T.C. Summ. Op. 2006-188 (debt was not discharged or dischargeable in this Ch. 13 bankruptcy).

The Mortgage Forgiveness Debt Relief Act of 2007 allows the exclusion of debt cancellation income from mortgage restructuring or mortgage foreclosure on a taxpayer’s home for debts forgiven for the years, 2007-2013.1  This Act has been extended numerous times and now covers the years 2014 through 2026. The exclusion is limited to $2 million ($1 million if filing status is married filing separately). The Act applies only to forgiveness or cancellation of debt to buy, build, or substantially improve a “principal residence” or to refinance debt incurred for these purposes. Refinanced home mortgage debt may include acquisition indebtedness and home equity debt. The home equity debt is not eligible for the qualified principal residence exclusion.2  Lenders’ principal reductions pursuant to the National Mortgage Settlement may qualify for exclusion from income under I.R.C. § 108(a)(1)(E) if the debt was acquisition debt and the cancellation occurred before January 1, 2014 or any extended date of the Act.

“Principal residence” in § 108 has the same meaning as in “principal residence” in I.R.C. § 121.3  A § 108(a)(1)(E) exclusion does not apply in a bankruptcy discharge.4  The § 108(a)(1)(B) insolvency exclusion does not apply to discharged debt to which § 108(a)(1)(E) applies unless the taxpayer elects a §108(1)(B) insolvency exception.5  A Form 982 must be filed with the taxpayer’s return to claim the § 108(a)(1)(E) exclusion from income.

Income excluded under I.R.C. §§ 108(a)(1)(A)–(C) must be applied to reduce the debtor’s “tax attributes.” As a practical matter, this reduction of basis in an indigent taxpayer’s assets will have little or no effect on the ultimate tax liability since the basis will likely be small. The basis in an asset is the price originally paid for it, along with certain maintenance and repair costs.

• 1Pub. L. No. 110-142, 121 Stat. 1803; see I.R.C. § 108(a)(1)(E).
• 2I.R.C. § 108(h)(4).
• 3See I.R.C. § 108(h)(2), (5).
• 4I.R.C. § 108(a)(2)(A).
• 5I.R.C. § 108(a)(2)(C).

A seller’s reduction in the price of the property does not give rise to cancellation of debt income.1  Instead, the buyer’ basis in the property is reduced. If a lender reduces the principal for an early payout or as part of a loan modification, the amount of cancelled debt is cancellation of debt income. However, if the debt is non-recourse and the owner retains the collateral, the owner does not have cancellation of debt income.

• 1I.R.C. § 108(e)(5).

Under I.R.C. § 102, a gratuitous release of a debt (something for nothing) may exclude debt cancellation from income. The issue is whether the creditor had a donative intent.1  Proving a §102 exclusion is difficult in consumer or commercial debt cases.

• 1See Plotinsky v. Comm’r, T.C. Memo 2008-244.

A Form 982 should be used to claim the insolvency, bankruptcy, or Mortgage Forgiveness Debt Relief Act exclusions from income. IRS Publication 4681 can be helpful to a correct preparation of a Form 982.