Cancellation of Debt

If property is conveyed to a creditor in satisfaction of debt, the amount of cancellation of debt income depends on whether the debt is recourse or nonrecourse. If property is conveyed in satisfaction or a recurse debt, the taxpayer/debtor has canecellation of debt (COD) income to the extent the fair market value of the property is less than the debt.

The conveyance of property to a creditor in satisfaction of nonrecourse debt results in gain (not cancellation of debt income) to the extent the debt is more than the taxpayer/debtor's basis in tproperty, or loss if the basis is more than the debt.

One area where the fair market value (FMV) is likely to be less than the debt is with real estate. After all the market has taken a tremendeous turn-around and prices have dropped like a rock.

Assuming that a taxpayer has COD income, it is necessary to determine whether that income can be excluded. Section 108(a)(1) provides five circumstances in which COD income is excluded:

 

  1. The discharge occurs in a Title 11 bankruptcy case. A debt discharge occurs in a Title 11 case only if the taxpayer is under the jurisdiction of the bankruptcy court and the discharge of indebtedness is granted by the court.

  2. ​​The discharge occurs when, and to the extent, the taxpayer is insolvent. An individual taxpayer is insolvent only if their liabilities exceed the FMV of their assets, and the amount by which the taxpayer is insolvent is determined immediately before the debt discharge.

  3. ​The indebtedness discharge is qualified farm indebtedness.

  4. ​In the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness.

  5. ​Qualified principal residence indebtedness discharged before 2010.

 

For more information on COD you should consult a professional tax practitioner or tax attorney.

 

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