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Publication 4681 2008 Tax Year

1.   Canceled Debts

Table of Contents

Generally, if a debt for which you are personally liable is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. A debt includes any indebtedness for which you are liable or which attaches to property you hold. Debt for which you are personally liable is recourse debt. All other debt is nonrecourse debt.

If you are not personally liable for the debt, you do not have ordinary income from the cancellation of debt unless the lender offers a discount for the early payment of the debt or agrees to a loan modification that results in the reduction of the principal balance of the debt. See Discounts and loan modifications, later. Also, upon the disposition of the property securing a nonrecourse debt, the amount realized includes the entire unpaid amount of the debt. As a result, you may realize a gain or loss if the outstanding debt immediately before the transfer differs from your adjusted basis in the property to which the debt relates. See Chapter 2, Foreclosures and Repossessions, or Publication 544, Sales and Other Dispositions of Assets, for more details on figuring your gain or loss.

There are several exceptions and exclusions that may result in part or all of your income from the cancellation of debt being nontaxable. See Exceptions and Exclusions, later. You must report any taxable amount as ordinary income from the cancellation of debt on:

  • Form 1040 or Form 1040NR, line 21, if the debt is a nonbusiness debt;

  • Schedule C (Form 1040), line 6 (or Schedule C-EZ (Form 1040), line 1), if the debt is related to a nonfarm sole propietorship;

  • Schedule E (Form 1040), line 3, if the debt is related to a nonfarm rental activity;

  • Form 4835, line 6, if the debt is related to a farm rental activity for which you use Form 4835 to report farm rental income based on crops or livestock produced by a tenant; or

  • Schedule F (Form 1040), line 10, if the debt is farm debt and you are a farmer.

Form 1099-C.   If an applicable financial entity cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2. Unless you meet one of the exceptions or exclusions discussed later, the canceled debt shown on Form 1099-C, box 2, is ordinary income from the cancellation of debt and must be reported on the appropriate form shown above.

  An applicable financial entity includes:

  • A federal government agency,

  • A financial institution,

  • A credit union, or

  • Any organization in which a significant part of its trade or business involves the lending of money.

Interest included in canceled debt.   If any interest is forgiven and included in the amount of canceled debt in box 2, the interest portion that is included in box 2 will be shown in box 3. Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it. See Deductible Debt under Exceptions, later.

  If the interest would not be deductible (such as interest on a personal loan) and you do not meet any other exception or exclusion discussed later, include in your income the amount from Form 1099-C, box 2. If the interest would be deductible (such as on a business loan) and you do not meet any other exception or exclusion discussed later, include in your income the net amount of the canceled debt (the amount shown in box 2 minus the interest amount shown in box 3).

Discounts and loan modifications.   If a lender offers to discount (reduce) the principal balance of a loan if the loan is paid off early or agrees to a loan modification (a “workout”) that includes a reduction in the principal balance of a loan, the amount of the discount or the amount of principal reduction is canceled debt whether or not you are personally liable for the debt. The amount of the canceled debt must be included in income unless certain exceptions or exclusions apply. For more details, see Exceptions and Exclusions, later.

Sales or other dispositions (such as foreclosures and repossessions).   If you owned property which was subject to a recourse debt in excess of the FMV of the property, the lender's foreclosure or repossession of the property may result in your realization of gain or loss on the disposition of the property. If the lender forgives all or part of the amount of the debt in excess of the FMV of the property, ordinary income may result from the cancellation of debt. The gain or loss on the disposition of the property is measured by the difference between the FMV of the property at the time of the disposition and your adjusted basis (usually your cost) in the property. The character of the gain or loss (such as ordinary or capital) on the disposition of the property is determined on the basis of the character of the property foreclosed. The ordinary income from the cancellation of debt (the excess of the canceled debt over the FMV of the property) must be included on your tax return unless certain exceptions or exclusions apply. For more details, see Exceptions and Exclusions, later.

  If you owned property which was subject to a nonrecourse debt in excess of the FMV of the property, the lender's foreclosure on the property does not result in ordinary income from the cancellation of debt. The entire amount of the nonrecourse debt is treated as an amount realized on the disposition of the property. The gain or loss on the disposition of the property is measured by the difference between the total amount realized (the entire amount of the nonrecourse debt plus the amount of cash and the FMV of any property received) and your adjusted basis in the property foreclosed. The character of the gain or loss on the disposition of the property is determined on the basis of the character of the property foreclosed.

  See Publication 523, Selling Your Home; Publication 544, Sales and Other Dispositions of Assets; Chapter 2, Foreclosures and Repossessions; and Publication 551, Basis of Assets; for more details.

Abandonments.   If the abandoned property secures a debt for which you are personally liable and the debt is canceled, you will realize ordinary income equal to the canceled debt. You must report this income on your return unless certain exceptions or exclusions apply. For more details, see Exceptions and Exclusions, later. This income is separate from any loss realized from the abandonment of the property. For more details, see Chapter 3, Abandonments.

Stockholder debt.   If you are a stockholder in a corporation and the corporation cancels or forgives your debt to it, the canceled debt is a constructive distribution that is generally dividend income to you. For more information, see Publication 542, Corporations.

Repayment of canceled debt.   If you included a canceled amount in your income and later pay all or a portion of the debt, you may be able to file a claim for refund for the year the amount was included in income. You can file a claim on Form 1040X, Amended U.S. Individual Income Tax Return, if the statute of limitations for filing a claim is still open. The statute of limitations generally does not end until 3 years after the due date of your original return.

Exceptions

There are several exceptions to the inclusion of canceled debt in income. These exceptions apply before the exclusions discussed later.

Amounts Otherwise Excluded From Income

Amounts otherwise excluded from income do not result in income from the cancellation of debt. For example, you have no income from the cancellation of debt if the cancellation of the debt is intended as a gift to you. See Publication 525, Taxable and Nontaxable Income, for more details on amounts that are excluded from income.

Student Loans

Certain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers.

You do not have income from the cancellation of debt if your student loan is canceled after you agreed to this provision and then performed the services required. To qualify, the loan must have been made by:

  1. The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof,

  2. A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or

  3. An educational institution (defined later):

    1. Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or

    2. As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization (defined later).

A loan to refinance a qualified student loan also will qualify if it was made by an educational institution or a tax-exempt section 501(a) organization under its program designed as described in (3)(b) above.

Exception.   You have ordinary income from the cancellation of debt if your student loan was made by an educational institution and is canceled because of services you performed for the institution or other organization that provided the funds. You must include this income on your return unless other exceptions or exclusions apply.

Education loan repayment assistance.   Education loan repayments made to you by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act are not taxable if you agree to provide primary health services in health professional shortage areas.

Educational institution.   An educational institution is an organization with a regular faculty and curriculum and a regularly enrolled body of students in attendance at the place where the educational activities are carried on.

Section 501(c)(3) organization.    A section 501(c)(3) organization is any corporation, community chest, fund, or foundation organized and operated exclusively for one or more of the following purposes.

  • Charitable.

  • Educational.

  • Fostering national or international amateur sports competition (but only if none of the organization's activities involve providing athletic facilities or equipment).

  • Literary.

  • Preventing cruelty to children or animals.

  • Religious.

  • Scientific.

  • Testing for public safety.

Deductible Debt

If you use the cash method of accounting, you do not realize income from the cancellation of debt if the payment of the debt would have been a deductible expense. This exception applies before the price reduction exception discussed below.

Example.

You get accounting services for your farm on credit. Later, you have trouble paying your farm debts and 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. Unless another exception or exclusion applies, you must include the canceled debt in ordinary income because the expense was deductible when you incurred the debt.

Price Reduced After Purchase

If debt you owe the seller for the purchase of property is reduced by the seller at a time when you are not insolvent and the reduction does not occur in a title 11 bankruptcy case, the reduction does not result in cancellation of debt income. However, you must reduce your basis in the property by the amount of the reduction of your debt to the seller. The rules that apply to bankruptcy and insolvency are explained in the next section, Exclusions.

Exclusions

There are several exclusions from the general rule of inclusion of canceled debt in income. These are explained next. Generally, if you exclude canceled debt from income under one of these provisions, you must also reduce your tax attributes (certain credits, losses, and basis of assets) as explained later under Reduction of Tax Attributes.

Bankruptcy

Debt canceled in a title 11 bankruptcy case is not included in your income. A title 11 bankruptcy case is a case under title 11 of the United States Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.

How to report the bankruptcy exclusion.   To show that your debt was canceled in a bankruptcy case and is excluded from income, attach Form 982 to your federal income tax return and check the box on line 1a. Lines 1b through 1e do not apply to a cancellation that occurs in a title 11 bankruptcy case. Enter the total amount of debt canceled in your title 11 bankruptcy case on line 2. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

Insolvency

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities exceeded the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:

  • The entire amount of recourse debts, and

  • The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.

Note.

This exclusion does not apply to a cancellation that occurs in a title 11 bankruptcy case. This exclusion also does not apply if the debt is qualified principal residence indebtedness (defined in this section under Qualified Principal Residence Indebtedness, later) unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion.

How to report the insolvency exclusion.   To show that you were insolvent and that you are excluding canceled debt from income to the extent you were insolvent immediately before the cancellation, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

Example 1.

In 2007, Greg was released from his obligation to pay his personal credit card debt in the amount of $5,000. Greg received a 2007 Form 1099-C from his credit card lender showing canceled debt of $5,000 in box 2. The FMV of Greg's total assets immediately before the cancellation was $7,000 and his total liabilities were $15,000. This means that immediately before the cancellation, Greg was insolvent to the extent of $8,000 ($15,000 total liabilities minus $7,000 FMV of his total assets). Because the amount by which Greg was insolvent immediately before the cancellation exceeds the amount of his debt canceled, Greg can exclude the entire $5,000 canceled debt from income.

When completing his tax return, Greg checks the box on line 1b of Form 982 and enters $5,000 on line 2. Greg completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Greg does not include any of the $5,000 canceled debt on line 21 of his Form 1040. None of the canceled debt is included in his income.

Example 2.

Assume the same facts as in Example 1 except that the FMV of Greg's total assets immediately before the cancellation was $7,000 and his total liabilities were $10,000. In this case, Greg is insolvent to the extent of $3,000 ($10,000 total liabilities minus $7,000 FMV of his total assets) immediately before the cancellation. Because the amount of the canceled debt exceeds the amount by which Greg was insolvent immediately before the cancellation, Greg can exclude only $3,000 of the $5,000 canceled debt from income under the insolvency exclusion.

Greg checks the box on line 1b of Form 982 and includes $3,000 on line 2. Also, Greg completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Additionally, Greg must include $2,000 of canceled debt on line 21 of his Form 1040 (unless another exception or exclusion applies).

Qualified Farm Indebtedness

You can exclude canceled farm debt from income if all of the following apply.

  • The debt was incurred directly in connection with the operation of the trade or business of farming.

  • 50% or more of your total gross receipts for 2004, 2005, and 2006 were from the trade or business of farming.

  • The cancellation was made by a qualified person. A qualified person is an individual, organization, etc., who is actively and regularly engaged in the business of lending money. A qualified person includes any federal, state, or local government, agency or instrumentality thereof. The United States Department of Agriculture is a qualified person. This person cannot be related to you, be the person from whom you acquired the property (or a person related to this person), or be a person who receives a fee due to your investment in the property (or a person related to this person).

For the definition of the term “related person,” see Related persons under At-Risk Amounts in Publication 925.

Note.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case or to the extent you were insolvent immediately before the cancellation. If qualified farm debt is canceled in a title 11 case, you must apply the bankruptcy exclusion rather than the exclusion for canceled qualified farm debt. If you were insolvent immediately before the cancellation of qualified farm debt, you must apply the insolvency exclusion before applying the exclusion for canceled qualified farm debt.

Exclusion limit.   The amount of canceled qualified farm debt that you can exclude from income is limited. It cannot exceed the sum of your adjusted tax attributes and the total adjusted bases of qualified property you held at the beginning of 2008. For purposes of determining the limit on the exclusion for canceled qualified farm debt, the adjusted basis of any qualified property and adjusted tax attributes are determined after any reduction of tax attributes required because of the application of the insolvency exclusion for canceled debt.

Adjusted tax attributes.   Adjusted tax attributes means the sum of the following items.

  1. Any net operating loss (NOL) for 2007 and any NOL carryover to 2007.

  2. Any net capital loss for 2007 and any capital loss carryover to 2007 under Internal Revenue Code section 1212.

  3. Any passive activity loss carryover from 2007.

  4. Three times the sum of any:

    1. General business credit carryover to or from 2007,

    2. Minimum tax credit available as of the beginning of 2008,

    3. Foreign tax credit carryover to or from 2007, and

    4. Passive activity credit carryover from 2007.

Qualified property.   This is any property you use or hold for use in your trade or business or for the production of income.

How to report the qualified farm indebtedness exclusion.   To show that all or part of your canceled debt is excluded from income because it is qualified farm debt, attach Form 982 to your federal income tax return and check the box on line 1c. On line 2 of Form 982, include the amount of qualified farm debt canceled, but not more than the amount of the exclusion limit (explained earlier). You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

Example 1.

In 2007, Chuck was released from his obligation to pay a $10,000 debt that was incurred directly in connection with his trade or business of farming. Chuck received a Form 1099-C from the qualified lender showing canceled debt of $10,000 in box 2. For the 2004, 2005, and 2006 tax years, at least 50% of Chuck's total gross receipts were from the trade or business of farming. Chuck's adjusted tax attributes are $5,000 and Chuck has $3,000 total adjusted bases in qualified property at the beginning of 2008. Chuck had no other debt canceled during 2007 and he does not fall into any other exception or exclusion relating to canceled debt income.

Chuck can exclude $8,000 ($5,000 of adjusted tax attributes plus $3,000 total adjusted bases in qualified property at the beginning of 2008) of the $10,000 canceled debt from income. Chuck checks the box on line 1c of Form 982 and enters $8,000 on line 2. Also, Chuck completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. The remaining $2,000 of canceled qualified farm debt is included in Chuck's income on Schedule F, line 10.

Example 2.

On March 1, 2007, Bob was released from his obligation to pay a $10,000 business credit card debt that was used directly in connection with his farming business. For the 2004, 2005, and 2006 tax years at least 50% of Bob's total gross receipts were from the trade or business of farming. Bob received a 2007 Form 1099-C from the qualified lender showing canceled debt of $10,000 in box 2. The FMV of Bob's total assets on March 1, 2007 (immediately before the cancellation of the credit card debt) was $7,000 and Bob's total liabilities at that time were $11,000. Bob's adjusted tax attributes (a 2007 NOL) are $7,000 and Bob has $4,000 total adjusted bases in qualified property at the beginning of 2008.

Bob qualifies to exclude $4,000 of the canceled debt under the insolvency exclusion because he is insolvent to the extent of $4,000 immediately before the cancellation ($11,000 total liabilities minus $7,000 FMV of total assets). Bob also qualifies to exclude the remaining $6,000 of canceled qualified farm debt. The limit on Bob's exclusion from income of canceled qualified farm debt is $7,000, the sum of his adjusted tax attributes of $3,000 (determined after taking into account the reduction of tax attributes required because of the exclusion of $4,000 of the canceled debt from Bob's income under the insolvency exclusion) plus $4,000 (Bob's total adjusted bases in qualified property at the beginning of 2008).

Bob checks the boxes on lines 1b and 1c of Form 982 and enters $10,000 on line 2. Bob completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Bob must reduce his tax attributes under the insolvency rules before applying the rules for qualified farm debt. Bob does not include any of his canceled debt in income.

Example 3.

Assume the same facts as in Example 2 except that immediately before the cancellation Bob was insolvent to the extent of the full $10,000 canceled debt. Because the exclusion for qualified farm debt does not apply to the extent that you were insolvent immediately before the cancellation, Bob checks only the box on line 1b of Form 982 and enters $10,000 on line 2. Bob completes Part II to reduce his tax attributes based on the insolvency exclusion as explained under Reduction of Tax Attributes, later. Bob does not include any of the canceled debt in income.

Qualified Real Property Business Indebtedness

You can elect to exclude canceled qualified real property business indebtedness from income. Qualified real property business indebtedness is debt (other than qualified farm debt) that meets all of the following conditions.

  1. It was incurred or assumed in connection with real property used in a trade or business.

  2. It is secured by such real property.

  3. It was incurred or assumed at either of the following times.

    1. Before 1993.

    2. After 1992, if the debt is either (i) qualified acquisition indebtedness (defined below), or (ii) debt incurred to refinance qualified real property business debt incurred or assumed before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced).

  4. It is debt to which you elect to apply these rules.

Qualified acquisition indebtedness.   Qualified acquisition indebtedness is:

  • Debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property that secures such debt, or

  • Debt resulting from the refinancing of qualified acquisition indebtedness, to the extent the amount of such debt does not exceed the amount of debt being refinanced.

Note.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case or to the extent you were insolvent immediately before the cancellation. If qualified real property business debt is canceled in a title 11 case, you must apply the bankruptcy exclusion rather than the exclusion for canceled qualified real property business debt. If you were insolvent immediately before the cancellation of qualified real property business debt, you must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business debt.

Exclusion limit.   The amount of canceled qualified real property business debt that you can exclude from income is limited. If you excluded canceled debt from income under the insolvency exclusion, you must reduce your tax attributes to account for the amount of the canceled debt excluded under the insolvency exclusion before determining your limit on the exclusion of canceled qualified real property business debt. Your exclusion for canceled qualified real property business debt is limited to the excess (if any) of:

  • The outstanding principal amount of the qualified real property business debt (immediately before the cancellation), over

  • The FMV (immediately before the cancellation) of the business real property securing such debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property (immediately before the cancellation).

  In addition to this limit, the amount of canceled qualified real property business debt that can be excluded from income cannot exceed the total adjusted bases (determined after any attribute reductions under Internal Revenue Code sections 108(b) and (g)) of depreciable real property you held immediately before the cancellation (other than depreciable real property acquired in contemplation of the cancellation).

How to elect the qualified real property business debt exclusion.   You must make an election to exclude canceled qualified real property business debt. The election must be made on a timely-filed (including extensions) federal income tax return for 2007 and can be revoked only with the consent of the IRS. The election is made by completing Form 982 in accordance with its instructions. Attach Form 982 to your federal income tax return for 2007 and check the box on line 1d. Include the amount of canceled qualified real property business debt (but not more than the amount of the exclusion limit, explained above) on line 2 of Form 982. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

  If you timely filed your tax return without making this election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Enter “Filed pursuant to section 301.9100-2” on the amended return and file it at the same place you filed the original return.

Example.

In 2002, Curt purchased a retail store for use in a business he operated as a sole proprietorship. Curt made a $20,000 down payment and financed the remaining $200,000 of the purchase price with a bank loan. The bank loan was a recourse loan and was secured by the property. Curt used the property in his business continuously since its acquisition. Curt had no other debt secured by that depreciable real property. In addition to the retail store, Curt owned depreciable equipment and furniture with an adjusted basis of $50,000.

Curt's business encountered financial difficulties in 2007. On September 25, 2007, the bank financing the retail store loan entered into a workout agreement with Curt under which it canceled $20,000 of the debt. Immediately before the cancellation, the outstanding principal balance on the retail store loan was $185,000, the FMV of the store was $165,000, and the adjusted basis was $210,000 ($220,000 cost minus $10,000 accumulated depreciation).

The bank sent Curt a 2007 Form 1099-C showing canceled debt of $20,000 in box 2. Curt had no tax attributes other than basis to reduce and did not qualify for any exception or exclusion other than the qualified real property business indebtedness exclusion.

Curt elects to apply the qualified real property business debt exclusion provisions to the canceled debt. The amount of canceled qualified real property business debt that Curt can exclude from income is limited to $20,000 (the excess of the $185,000 outstanding principal amount of his qualified real property business debt immediately before the cancellation over the $165,000 FMV of the business real property securing such debt). Curt's exclusion of canceled qualified real property business debt is also subject to a $210,000 limit equal to the adjusted basis of depreciable real property he held immediately before the cancellation.

Thus, Curt can exclude the entire $20,000 of canceled qualified real property business debt from income. Curt checks the box on line 1d of Form 982 and enters $20,000 on line 2. Curt must also use line 4 of Form 982 to reduce his basis in depreciable real property by the $20,000 of canceled qualified real property business debt excluded from his income as explained under Reduction of Tax Attributes, later.

Qualified Principal Residence Indebtedness

You can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any debt incurred in acquiring, constructing, or substantially improving your principal residence and which is secured by your principal residence. Qualified principal residence indebtedness also includes any debt secured by your principal residence resulting from the refinancing of debt incurred to acquire, construct, or substantially improve your principal residence but only to the extent the amount of debt does not exceed the amount of the refinanced debt.

Example.

In 1995, Becky purchased a principal residence for $315,000. Becky took out a $300,000 mortgage loan to buy the principal residence and made a down payment of $15,000. The loan was secured by the principal residence. In 1996, Becky took out a second mortgage loan in the amount of $50,000 that she used to add a garage to her home.

In 2001, when the outstanding principal of her first and second mortgage loans was $325,000, Becky refinanced the two loans into one loan in the amount of $400,000. The FMV of the principal residence at the time of the refinancing was $430,000. Becky used the additional $75,000 debt ($400,000 new mortgage loan minus $325,000 outstanding principal balances of Becky's first and second mortgage loans immediately before the refinancing) to pay off personal credit cards and to pay college tuition for her daughter.

After the refinancing, Becky's qualified principal residence indebtedness is $325,000 because the debt resulting from the refinancing is qualified principal residence indebtedness only to the extent the amount of debt does not exceed the amount of the refinanced debt.

Principal residence.   Your principal residence is the home where you ordinarily live most of the time. You can have only one principal residence at any one time.

Note.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case. If qualified principal residence indebtedness is canceled in a title 11 bankruptcy case, you must apply the bankruptcy exclusion rather than the exclusion for qualified principal residence indebtedness. If you were insolvent immediately before the cancellation, you can elect to apply the insolvency exclusion (as explained under Insolvency, earlier) instead of applying the qualified principal residence indebtedness exclusion. To do this, check the box on line 1b of Form 982 instead of the box on line 1e.

Exclusion limit.   The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). You cannot exclude canceled qualified principal residence indebtedness from income if the cancellation was for services performed for the lender or on account of any other factor not directly related to a decline in the value of your residence or to your financial condition.

Ordering rule.   If only a part of a loan is qualified principal residence indebtedness, the exclusion from income for canceled qualified principal residence indebtedness applies only to the extent the amount canceled exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another exclusion, as discussed earlier.

Example.

Ken incurred recourse debt of $800,000 when he purchased his principal residence for $880,000. When the FMV of the property was $1,000,000, Ken refinanced the debt for $850,000. At the time of the refinancing, the principal balance of the original mortgage loan was $740,000. Ken used the $110,000 he obtained from the refinancing ($850,000 minus $740,000) to pay off his credit cards and to buy a new car.

About two years after the refinancing, Ken lost his job and was unable to get another position paying a comparable salary. Ken's residence had declined in value to between $700,000 and $750,000. Based on Ken's circumstances, the lender agreed to allow a short sale of the property for $735,000 and to cancel the remaining $115,000 of the $850,000 debt. Under the ordering rule, Ken can exclude only $5,000 of the canceled debt from his income under the exclusion for canceled qualified principal residence indebtedness ($115,000 canceled debt minus the $110,000 amount of the debt that was not qualified principal residence indebtedness). Ken must include the remaining $110,000 of canceled debt in income on line 21 of his Form 1040 (unless another exception or exclusion applies).

How to report the qualified principal residence indebtedness exclusion.   To show that all or part of your canceled debt is excluded from income because it is qualified principal residence indebtedness, attach Form 982 to your federal income tax return and check the box on line 1e. On line 2 of Form 982, include the amount of canceled qualified principal residence indebtedness, but not more than the amount of the exclusion limit (explained earlier). If you continue to own your residence after a cancellation of qualified principal residence indebtedness, you must reduce your basis in the residence as explained under Reduction of Tax Attributes, next.

Reduction of Tax Attributes

If you exclude canceled debt from income, you must reduce certain tax attributes (but not below zero) by the amount excluded. Use Part II of Form 982 to reduce your tax attributes. The order in which the tax attributes are reduced depends on the reason the canceled debt was excluded from income. If the total amount of canceled debt excluded from income (line 2 of Form 982) was more than your total tax attributes, the total reduction of tax attributes in Part II of Form 982 will be less than the amount on
line 2.

Qualified Principal Residence Indebtedness

If you exclude the canceled qualified principal residence indebtedness from income and you continue to own the residence after the cancellation, you must reduce the basis of the residence (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Enter the amount of the basis reduction on line 10b of Form 982.

For more details on determining the basis of your principal residence, see Publication 523, Selling Your Home.

Bankruptcy and Insolvency

No tax attributes other than basis of personal use property.   If the canceled debt you are excluding is a debt other than qualified principal residence indebtedness (such as a car loan or credit card debt) and you have no tax attributes other than the adjusted bases of personal use property you own (see the list of seven tax attributes, later), you must reduce the bases of the personal use property you held at the beginning of 2008 (in proportion to adjusted basis). Personal use property is any property that is not used in your trade or business nor held for investment (such as your home furnishings, vehicle, and residence). Include on line 10a of Form 982 the smallest of:

  • The bases of your personal use property held at the beginning of 2008,

  • The amount of the nonbusiness debt (other than qualified principal residence indebtedness) that you are excluding from income on line 2 of Form 982, or

  • The excess of the total bases of the property and the amount of money you held immediately after the cancellation over your total liabilities immediately after the cancellation.

Example.

In 2004, Kyra bought a car for personal use. The cost of the car was $12,000. Kyra put down $2,000 and took out a loan of $10,000 to help with the purchase. The loan was a recourse loan, meaning that Kyra was personally liable for the full amount of the debt.

On December 7, 2007, when the balance of the loan was $8,500, Kyra was unable to make payments and the lender repossessed the car. The car had a FMV of $7,000 at the time of repossession. At the time of the repossession, the lender forgave the remaining $1,500 balance due on the car loan ($8,500 outstanding balance immediately before the repossession minus $7,000 FMV).

Kyra's only other assets at the time of the cancellation are the furniture in her apartment which has a cost basis of $5,000 and a FMV of $3,000, jewelry with a basis of $500 and a FMV of $1,000, and a $600 balance in her savings account. Thus, the FMV of Kyra's total assets immediately before the cancellation was $11,600 ($7,000 car plus $3,000 furniture plus $1,000 jewelry plus $600 savings). Kyra also had an outstanding student loan balance of $6,000 immediately before the cancellation, bringing her total liabilities at that time to $14,500 ($8,500 balance on car loan plus $6,000 student loan balance). Other than the car, which was repossessed, Kyra held all of these assets at the beginning of 2008. The FMV and bases of the assets remained the same at the beginning of 2008.

Kyra received a 2007 Form 1099-C showing $1,500 in box 2 (amount of debt canceled) and $7,000 in box 7 (FMV of the property). Kyra can exclude all of $1,500 canceled debt from income because at the time of the cancellation, she was insolvent to the extent of $2,900 ($14,500 of total liabilities immediately before the cancellation minus $11,600 FMV of total assets at that time).

Kyra checks box 1b on Form 982 and enters $1,500 on line 2. Kyra enters $100 on line 10a (the smallest of: (a) the $5,500 bases of Kyra's personal use property held at the beginning of 2008 ($5,000 furniture plus $500 jewelry), (b) the $1,500 amount of nonbusiness debt she is excluding from income on line 2 of Form 982, or (c) the $100 excess of the total bases of the property and the amount of money Kyra held immediately after the cancellation over Kyra's total liabilities at that time ($5,500 bases of property held immediately after the cancellation plus $600 savings minus $6,000 student loan).

Kyra must reduce her bases in her property in proportion to her adjusted bases in the property. Thus, Kyra reduces her basis in the furniture by $ 91 ($100 x 5,000/5,500) and her basis in the jewelry by $9 ($100 x 500/5,500).

All other tax attributes.   If the canceled debt is excluded by reason of bankruptcy or insolvency, you must use the excluded debt to reduce the following tax attributes (but not below zero) in the order listed unless you elect to reduce the basis of depreciable property first, as explained later. The reduction of tax attributes must be made after figuring your income tax liability for 2007.

  

  1. Net operating loss (NOL). First reduce any 2007 NOL and then reduce any NOL carryover to 2007 in the order of the tax years from which the carryovers arose, starting with the earliest year. Reduce the NOL or carryover by one dollar for each dollar of excluded canceled debt.

  2. General business credit carryover. Reduce the credit carryover to or from 2007. Reduce the credit carryovers to 2007 in the order in which they are taken into account for 2007. Reduce the carryover by 33⅓ cents for each dollar of excluded canceled debt.

  3. Minimum tax credit. Reduce the minimum tax credit available at the beginning of 2008. Reduce the credit by 33⅓ cents for each dollar of excluded canceled debt.

  4. Capital loss. First reduce any 2007 net capital loss and then any capital loss carryover to 2007. Reduce the capital loss or carryover by one dollar for each dollar of excluded canceled debt.

  5. Basis. Reduce the bases of the property you hold at the beginning of 2008 in the following order (and within each category, in proportion to adjusted basis).

    1. Real property (except inventory) used in your trade or business or held for investment that secured the canceled debt.

    2. Personal property (except inventory and accounts and notes receivable) used in your trade or business or held for investment that secured the canceled debt.

    3. Other property (except inventory, accounts and notes receivable, and real property held primarily for sale to customers) used in your trade or business or held for investment.

    4. Inventory, accounts and notes receivable, and real property held primarily for sale to customers.

    5. Personal use property (property not used in your trade or business nor held for investment).

    Reduce the basis by one dollar for each dollar of excluded canceled debt. However, the reduction cannot be more than the excess of the total bases of the property and the amount of money you held immediately after the debt cancellation over your total liabilities immediately after the cancellation.

    For allocation rules that apply to basis reductions for multiple canceled debts, see Regulations section 1.1017-1(b)(2). Also see Election to reduce the basis of depreciable property before reducing other tax attributes, later.

  6. Passive activity loss and credit carryovers. Reduce the passive activity loss and credit carryovers from 2007. Reduce the loss carryover by one dollar for each dollar of excluded canceled debt. Reduce the credit carryover by 33⅓ cents for each dollar of excluded canceled debt.

  7. Foreign tax credit. Reduce the credit carryover to or from 2007. Reduce the credit carryovers to 2007 in the order in which they are taken into account for 2007. Reduce the carryover by 33⅓ cents for each dollar of excluded canceled debt.

Election to reduce the basis of depreciable property before reducing other tax attributes.   You can elect to apply any portion of the tax attribute reduction required because of the exclusion of canceled debt to the reduction under section 1017 of the bases of depreciable property you held at the beginning of 2008. Basis of property is reduced in the following order:

  1. Depreciable real property used in your trade or business or held for investment that secured the canceled debt.

  2. Depreciable personal property used in your trade or business or held for investment that secured the canceled debt.

  3. Other depreciable property used in your trade or business or held for investment.

  4. Real property held primarily for sale to customers if you elect to treat it as if it were depreciable property on Form 982.

  Basis reduction is limited to the total adjusted bases of all your depreciable property. Depreciable property for this purpose means any property subject to depreciation or amortization, but only if a reduction of basis will reduce the depreciation or amortization otherwise allowable for the period immediately following the basis reduction. If the amount of canceled debt excluded from income is more than the total bases in depreciable property, the excess is applied to reduce the other tax benefits in accordance with the general ordering rules for reduction of tax attributes described earlier under Bankruptcy and Insolvency. In figuring the limit on the basis reduction in (5), Basis, use the remaining adjusted bases of your properties after making this election. See Form 982 for information on how to make this election. The election can be revoked 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 depreciation adjustments that would have resulted under the straight line method as if there were no basis reduction for debt cancellation. See Publication 535, Business Expenses, or Publication 225, Farmer's Tax Guide, for more details on sections 1245 and 1250 property and the recapture of gain as ordinary income.

Qualified Farm Indebtedness

If you exclude canceled debt from income under both the insolvency exclusion and the exclusion for qualified farm indebtedness, you must reduce your tax attributes by the amount excluded under the insolvency exclusion before applying the exclusion for canceled qualified farm indebtedness. You must then reduce your remaining tax attributes (but not below zero) by the amount of canceled debt that qualifies for the farm debt exclusion.

Generally, when reducing your tax attributes for canceled qualified farm indebtedness excluded from income, you must follow the ordering rules for reduction of tax attributes, previously explained under Bankruptcy and Insolvency. However, do not follow the rules in item (5), Basis. Instead, only reduce the basis of qualified property. Qualified property is any property you use or hold for use in your trade or business or for the production of income. Reduce the basis of qualified property in the following order.

  1. Depreciable qualified property. You can elect on Form 982 to treat real property held primarily for sale to customers as if it were depreciable property.

  2. Land that is qualified property and is used or held for use in your farming business.

  3. Other qualified property.

Qualified Real Property Business Indebtedness

If you make an election to exclude canceled qualified real property business debt from income, you must reduce the basis of your depreciable real property (but not below zero) by the amount of canceled qualified real property business debt excluded from income. The basis reduction is made at the beginning of 2008. However, if you dispose of your depreciable real property before the beginning of 2008, you must reduce the basis of the depreciable real property (but not below zero) immediately before the disposition. Enter the amount of the basis reduction on line 4 of Form 982.

Example 1.

In 2002, Curt purchased a retail store for use in a business he operated as a sole proprietorship. Curt made a $20,000 down payment and financed the remaining $200,000 of the purchase price with a bank loan. The bank loan was a recourse loan and was secured by the property. Curt used the property in his business continuously since its acquisition. Curt had no other debt secured by that depreciable real property. In addition to the retail store, Curt owned depreciable equipment and furniture with an adjusted basis of $50,000. Curt's tax attributes included the basis of depreciable property, a net operating loss, and a capital loss carryover to 2007.

Curt's business encountered financial difficulties in 2007. On September 25, 2007, the bank financing the retail store loan entered into a workout agreement with Curt under which it canceled $20,000 of the debt. Immediately before the bank entered into the workout agreement, Curt was insolvent to the extent of $12,000. At that time, the outstanding principal balance on the retail store loan was $185,000, the FMV of the store was $165,000, and the adjusted basis was $210,000 ($220,000 cost minus $10,000 accumulated depreciation). The bank sent Curt a 2007 Form 1099-C showing canceled debt of $20,000 in box 2.

Curt must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business indebtedness. Under the insolvency exclusion rules, Curt can exclude $12,000 of the canceled debt from income. Curt elects to reduce his basis of depreciable property before reducing other tax attributes. Under that election, Curt must first reduce his basis in the depreciable real property used in his trade or business that secured the canceled debt. After the basis reduction, Curt's adjusted basis in the depreciable real property securing the canceled debt is $198,000 ($210,000 adjusted basis before entering into the workout agreement minus $12,000 of canceled debt excluded from income under the insolvency exclusion).

The exclusion for qualified real property business indebtedness is limited to $20,000, the excess of the outstanding principal amount of the qualified real property business indebtedness (immediately before the cancellation) over the FMV (immediately before the cancellation) of the real property securing such debt ($185,000 minus $165,000). Curt's exclusion is also limited to $198,000, the total adjusted bases (determined after reduction for the canceled debt excluded under the insolvency exclusion) of his depreciable real property he held immediately before the cancellation. Since both of these limits exceed the $8,000 of remaining canceled debt ($20,000 minus $12,000), Curt can exclude $8,000 under the qualified real property business indebtedness exclusion.

Curt checks the boxes on lines 1b and 1d of Form 982. He completes Part II of Form 982 to reduce his bases in the depreciable real property by $20,000, the amount of the canceled debt excluded from income. Curt enters $8,000 on line 4 and $12,000 on line 5.

Example 2.

Bob owns depreciable real property used in his retail business. His adjusted basis in the property is $145,000. The FMV of the property is $120,000. The property is subject to $134,000 of recourse debt which is secured by the property. Bob had no other debt secured by that depreciable real property. Bob also had a $15,000 NOL in 2007.

During 2007, Bob entered into a workout agreement with the lender under which the lender canceled $14,000 of the debt on the real property used in Bob's business. Immediately before the cancellation, Bob was insolvent to the extent of $10,000. Bob excludes $10,000 of the canceled debt from income under the insolvency exclusion. As a result of that exclusion, Bob reduced his NOL by $10,000.

If Bob elects to apply the qualified real property business indebtedness exclusion provisions to the canceled debt, he can exclude the remaining $4,000 of canceled debt from income under the exclusion for canceled qualified real property business indebtedness. The exclusion limit based on the excess of the outstanding principal amount of the qualified real property business debt (immediately before the cancellation) over the FMV (immediately before the cancellation) of the business real property securing such debt ($134,000 minus $120,000) and the exclusion limit that the amount of canceled qualified real property business debt that can be excluded from income cannot exceed the total adjusted bases (determined after any attribute reductions under Internal Revenue Code sections 108(b) and (g)) of depreciable property held immediately before the cancellation (at least $145,000) both exceed the remaining $4,000 of canceled debt.

Bob checks the boxes on lines 1b and 1d of Form 982 and enters $14,000 on line 2. Bob completes Part II of Form 982 to reduce his basis of depreciable real property and his 2007 NOL by entering $4,000 on line 4 and $10,000 on line 6. None of the canceled debt is included in Bob's income.

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