Tax consequences of income from discharge of indebtedness

Scott Hogan
Foster Swift

Section 61 of the Internal Revenue Code establishes that all income, from whatever source derived, is included in gross income. If the income arises from a sale or exchange of property that is not a capital asset or property used in a trade or business then it is taxed as ordinary income.

Section 61(a)(12) specifically includes income from discharge of indebtedness as gross income. Income from discharge of indebtedness occurs where any amount of debt is forgiven and is no longer an obligation of the taxpayer. For example, if less than the remaining balance of a debt is accepted as complete satisfaction of the debt, the amount forgiven is considered ordinary income to the taxpayer as a gain arising from the exchange of property – the debt. Another example would be a loan for $100,000, on which the taxpayer paid $75,000 and the lender forgave $25,000. The taxpayer would owe taxes on the forgiven $25,000.

Unless an exception applies, an individual or corporation must pay taxes on the amount of discharged debt even though they received nothing tangible to pay the tax with. The exceptions to this rule recognize that many taxpayers had their debt forgiven due to inability to pay, and requiring them to then come up with the money to pay the tax is unfeasible. Section 108(a) excludes from gross income the discharge of debt due to a federal bankruptcy case or when the taxpayer is insolvent. Any amount of discharged debt excluded due to insolvency is limited to the amount of insolvency; any amount forgiven beyond that would be included in gross income.

If the discharged debt is a business debt, the taxpayer’s tax attributes – such as any net operating loss, general business credit carryover or basis in property – are reduced by any amount excluded from gross income. Tax attributes are considered valuable assets for a corporation, and Section 108(b) aims to prevent businesses from strategically benefiting through bankruptcy or insolvency by deducting both discharged debt and net losses.

Other exclusions include qualified farm indebtedness, qualified real property business indebtedness for a taxpayer that is not a C corporation, and qualified principal residence indebtedness discharged before January 1, 2018 or subject to an arrangement entered prior to January 1, 2018. In each instance, the term “qualified” refers to the requirement that the debt come from an individual or organization in the business of lending money, as opposed to a related person, the person who sold the property, or a person who receives a fee in relation to the taxpayer’s investment.

Qualified farm indebtedness is limited to debt from the business of farming, and requires the taxpayer to demonstrate that at least 50 percent of their aggregate gross receipts for the last three years relate to the trade or business of farming. Qualified real property business indebtedness is limited to debt incurred prior to January 1, 1993 for real property used in a trade or business, or debt incurred after January 1, 1993 to refinance, acquire, construct, or substantially improve real property used in a trade or business. Qualified principal residence indebtedness is limited to a mortgage secured by the taxpayer’s principal residence used to buy, build, or substantially improve the home. Discharged debt incurred through a mortgage for other purposes, such as a home equity line, would be included as gross income.

There is also an exception for student loan forgiveness in Section 108(f), if the forgiveness is due to a provision in the loan stating that all or part of the debt would be discharged if the individual worked for a certain period of time in a certain profession for a broad class of employers. Any taxpayer claiming an exclusion from gross income for the discharge of indebtedness must file a Form 982 with the IRS with their tax return for the year in which the discharge occurred.

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Scott Hogan is a shareholder in Foster Swift’s Grand Rapids office, practicing in the areas of real estate, municipal and library law, business law, receiverships, and bankruptcy.