Publication 225 |
2000 Tax Year |
Cancellation of Debt
The following explains the general rule for including canceled debt
in income and the exceptions to the general rule.
General Rule
Generally, if your debt is canceled or forgiven, other than as a
gift or bequest to you, you must include the canceled amount in gross
income for tax purposes. Report the canceled amount on line 10 of
Schedule F if you incurred the debt in your farming business. If the
debt is a nonbusiness debt, report the canceled amount on line 21 of
Form 1040.
Form 1099-C.
If a federal agency, financial institution, or credit union cancels
or forgives your debt of $600 or more, you will receive a Form
1099-C, Cancellation of Debt. The amount of debt
canceled is shown in box 2.
Exceptions
The following discussion covers some exceptions to the general rule
for canceled debt.
Price reduced after purchase.
If you owe a debt to the seller for property you bought, and the
seller reduces the amount you owe, you generally do not have income
from the reduction. Unless you are in bankruptcy or are insolvent,
treat the amount of the reduction as a purchase price adjustment and
reduce your basis in the property. The rules that apply to bankruptcy
and insolvency are explained under Exclusions, later.
Deductible debt.
You do not realize income from a canceled debt to the extent the
payment of the debt would have led to a deduction.
Example.
You get accounting services for your farm on credit. Later, you
have trouble paying your farm debts, but you are not bankrupt or
insolvent. Your accountant forgives part of the amount you owe for the
accounting services. How you treat the canceled debt depends on your
method of accounting.
- Cash method - You do not include the canceled debt in
income because payment of the debt would have been deductible as a
business expense.
- Accrual method - You include the canceled debt in
income because the expense was deductible when you incurred the
debt.
Exclusions
Do not include canceled debt in income in the following situations.
- The cancellation takes place in a bankruptcy case under
title 11 of the U.S. Code.
- The cancellation takes place when you are insolvent.
- The canceled debt is a qualified farm debt.
- The canceled debt is a qualified real property business debt
(in the case of a taxpayer other than a C corporation). For
information on this type of canceled debt, see chapter 5 in
Publication 334.
If a canceled debt is excluded from income because it takes place
in a bankruptcy case, the exclusions in situations (2), (3), and (4)
do not apply. If it takes place when you are insolvent, the exclusions
in situations (3) and (4) do not apply to the extent you are
insolvent.
See Form 982, later, for information on how to claim an
exclusion for a canceled debt.
Debt.
For purposes of this discussion, debt includes any debt for which
you are liable or which attaches to property you hold.
Bankruptcy and Insolvency
You can exclude a canceled debt from income if you are bankrupt or
to the extent you are insolvent.
Bankruptcy.
A bankruptcy case is a case under title 11 of the U.S. Code if you
are under the jurisdiction of the court and the cancellation of the
debt is granted by the court or is the result of a plan approved by
the court.
Do not include debt canceled in a bankruptcy case in your gross
income in the year it is canceled. Instead, you must use the amount
canceled to reduce your tax benefits, explained later under
Reduction of tax benefits.
Insolvency.
You are insolvent to the extent your liabilities are more than the
fair market value of your assets immediately before the cancellation
of debt.
You can exclude canceled debt from gross income up to the amount by
which you are insolvent. If the canceled debt is more than the amount
by which you are insolvent and the debt qualifies, you can apply the
rules for qualified farm debt or qualified real property business debt
to the excess. Otherwise, you include the excess in gross income. Use
the amount excluded because of insolvency to reduce any tax benefits,
as explained later under Reduction of tax benefits. You
must reduce the tax benefits under the insolvency rules before
applying the rules for qualified farm debt or for qualified real
property business debt.
Example.
You had a $15,000 debt canceled outside of bankruptcy. Immediately
before the cancellation, your liabilities totaled $80,000 and your
assets totaled $75,000. Since your liabilities were more than your
assets, you were insolvent to the extent of $5,000 ($80,000 -
$75,000). You can exclude this amount from income. The remaining
canceled debt ($10,000) may be subject to the qualified farm debt or
qualified real property business debt rules. If not, you must include
it in income.
Reduction of tax benefits.
If you exclude canceled debt from income in a bankruptcy case or
during insolvency, you must use the excluded debt to reduce certain
tax benefits. This prevents an excessive tax benefit from the
cancellation.
Order of reduction.
You must use the excluded canceled debt to reduce the following tax
benefits in the order listed, unless you choose to reduce the basis of
depreciable property first, as explained later.
- Net operating loss (NOL). Reduce any NOL for the
tax year of the debt cancellation, and then any NOL carryover to that
year. Reduce the NOL or NOL carryover one dollar for each dollar of
excluded canceled debt.
- General business credit carryover. Reduce the
credit carryover to or from the tax year of the debt cancellation.
Reduce the carryover 33 1/3 cents for each dollar of
excluded canceled debt.
- Minimum tax credit. Reduce the minimum tax credit
available at the beginning of the tax year following the tax year of
the debt cancellation. Reduce the credit 33 1/3 cents for
each dollar of excluded canceled debt.
- Capital loss. Reduce any net capital loss for the
tax year of the debt cancellation, and then any capital loss carryover
to that year. Reduce the capital loss or loss carryover one dollar for
each dollar of excluded canceled debt.
- Basis. Reduce the basis of the property you hold
at the beginning of the tax year following the tax year of the debt
cancellation in the following order.
- Real property (except inventory) used in your trade or
business or held for investment that secured the canceled debt.
- Personal property (except inventory and accounts and notes
receivable) used in your trade or business or held for investment that
secured the canceled debt.
- Other property (except inventory and accounts and notes
receivable) used in your trade or business or held for
investment.
- Inventory and accounts and notes receivable.
- Other property.
Reduce the basis one dollar for each dollar of excluded canceled
debt. However, the reduction cannot be more than the total bases of
property and the amount of money you hold immediately after the debt
cancellation minus your total liabilities immediately after the
cancellation.
For allocation rules that apply to basis reductions for multiple
canceled debts, see section 1.1017-1(b)(2) of the regulations.
Also see Choosing to reduce the basis of depreciable property
first, later.
- Passive activity loss and credit carryovers.
Reduce the passive activity loss and credit carryovers from the
tax year of the debt cancellation. Reduce the loss carryover one
dollar for each dollar of excluded canceled debt. Reduce the credit
carryover 33 1/3 cents for each dollar of excluded
canceled debt.
- Foreign and possession tax credits. Reduce the
credit carryover to or from the tax year of the debt cancellation.
Reduce the carryover 33 1/3 cents for each dollar of
excluded canceled debt.
How to make tax benefit reductions.
Always make the required reductions in tax benefits after figuring
your tax for the year of the debt cancellation. In making the
reductions in (1) and (4) above, first reduce the loss for the tax
year of the debt cancellation. Then reduce any loss carryovers to that
year in the order of the tax years from which the carryovers arose,
starting with the earliest year. In making the reductions in (2) and
(7) above, reduce the credit carryovers to the tax year of the debt
cancellation in the order in which they are taken into account for
that year.
Choosing to reduce the basis of depreciable property first.
You can choose to apply any portion of the excluded canceled debt
first to reduce the basis of depreciable property you hold at the
beginning of the tax year following the tax year of the debt
cancellation, in the following order.
- Depreciable real property used in your trade or business or
held for investment that secured the canceled debt.
- Depreciable personal property used in your trade or business
or held for investment that secured the canceled debt.
- Other depreciable property used in your trade or business or
held for investment.
- Real property held as inventory if you elect to treat it as
depreciable property on Form 982.
The amount you apply cannot be more than the total adjusted bases
of all the depreciable property. Depreciable property, for this
purpose, means any property subject to depreciation, but only if a
reduction of basis will reduce the depreciation or amortization
otherwise allowable for the period immediately following the basis
reduction.
You make this reduction before reducing the other tax benefits
listed earlier. If the excluded canceled debt is more than the basis
reduction you can make under this choice, use the excess to reduce the
other tax benefits. In figuring the limit on the basis reduction in
(5), Basis, use the remaining adjusted bases of your
property after making this choice.
See Form 982, later, for information on how to make this
choice. If you make this choice, you can revoke it only with the
consent of the IRS.
Recapture of basis reductions.
If you reduce the basis of property under these provisions and
later sell or otherwise dispose of the property at a gain, the part of
the gain due to this basis reduction is taxable as ordinary income
under the depreciation recapture provisions. Treat any property that
is not section 1245 or section 1250 property as section 1245 property.
For section 1250 property, determine the straight-line depreciation
adjustments as though there were no basis reduction for debt
cancellation. Sections 1245 and 1250 property and the recapture of
gain as ordinary income are explained in chapter 11.
More information.
For more information on debt cancellation in bankruptcy proceedings
or during insolvency, see Publication 908.
Qualified Farm Debt
You can exclude from income a canceled debt that is qualified farm
debt owed to a qualified person. This exclusion applies only if you
were solvent when the debt was canceled or, if you were insolvent,
only to the extent the canceled debt is more than the amount by which
you were insolvent. Your debt is qualified farm debt if both the
following requirements are met.
- You incurred it directly in operating a farming
business.
- At least 50% of your total gross receipts for the 3 tax
years preceding the year of debt cancellation were from your farming
business.
Qualified person.
This is a person who is actively and regularly engaged in the
business of lending money. A qualified person includes any federal,
state, or local government, or any of their agencies or subdivisions.
These rules apply to debts canceled by the USDA.
A qualified person does not include any of the following.
- A person related to you.
- A person from whom you got the property (or a person related
to this person).
- A person who receives a fee from your investment in the
property (or a person related to this person).
For the definition of a related person, see Related persons
under At-Risk Amounts in Publication 925.
Exclusion limit.
The amount of canceled qualified farm debt you can exclude from
income is limited. It cannot be more than the sum of your adjusted tax
benefits and the total adjusted bases of the qualified property you
hold at the beginning of the tax year following the tax year of the
debt cancellation. Figure this limit after taking into account any
reduction of tax benefits because of debt canceled during insolvency.
If the canceled debt is more than this limit, you must include the
difference in gross income.
Adjusted tax benefits.
Adjusted tax benefits means the sum of the following items.
- Any net operating loss (NOL) for the tax year of the debt
cancellation and any NOL carryover to that year.
- Any general business credit carryover to or from the year of
the debt cancellation, multiplied by 3.
- Any minimum tax credit available at the beginning of the tax
year following the tax year of the debt cancellation, multiplied by
3.
- Any net capital loss for the tax year of the debt
cancellation and any capital loss carryover to that year.
- Any passive activity loss and credit carryovers from the tax
year of the debt cancellation. Any credit carryover is multiplied by
3.
- Any foreign and possession tax credit carryovers to or from
the tax year of the debt cancellation, multiplied by 3.
You multiply the credits by 3 to make them comparable with the
deduction benefits.
Qualified property.
This is any property you use or hold for use in your trade or
business or for the production of income.
Reduction of tax benefits.
If you exclude canceled debt from income under the qualified farm
debt rules, you must use the excluded debt to reduce tax benefits. (If
you also excluded canceled debt under the insolvency rules, you reduce
the amount of the tax benefits remaining after reduction for the
exclusion allowed under those rules.) You generally must follow the
reduction rules previously explained under Bankruptcy and
Insolvency. However, do not follow the rules in item (5),
Basis. Instead, follow the special rules explained next.
Special rules for reducing the basis of property.
You must use special rules to reduce the basis of property for
excluded canceled qualified farm debt. Under these special rules, you
only reduce the basis of qualified property (defined earlier). Reduce
it in the following order.
- Depreciable qualified property. You may choose on Form 982
to treat real property held as inventory as depreciable
property.
- Land that is qualified property and is used or held for use
in your farming business.
- Other qualified property.
Form 982
Use Form 982 to show the amounts of canceled debt excluded from
income and the reduction of tax benefits in the order listed on the
form. Also use it if you are making the choice to apply the excluded
canceled debt to reduce the basis of depreciable property before
reducing tax benefits. You make this choice by showing the amount you
choose to apply on line 5 of the form.
When to file.
You must file Form 982 with your timely filed income tax return
(including extensions) for the tax year in which the cancellation of
debt occurred. If you timely filed your return for the year without
making the choice to apply the excluded canceled debt to reduce the
basis of depreciable property first, you can still make the choice by
filing an amended return within six months of the due date of the
return (excluding extensions). For more information, see When to
file in the form instructions.
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