T5

Federal tax law requires that a taxpayer report as income the amount of any debt that is
canceled, unless such canceled debt is either a gift or bequest. Non-business debt that is
canceled is reported on 1040, line 21. Canceled business debt, is reported on Schedule C or
Schedule C-EZ (form 1040) (or on schedule F, Profit or Loss from Farming (Form 1040).
If you are personally liable for a mortgage (recourse debt), and you are relieved of the
mortgage when you dispose of the property, you may realize gain or loss up to the fair market
value of the property. If mortgage discharge exceeds the fair market value of the property it is
income from discharge of indebtedness unless it qualifies for exclusion.

Canceled debt is not included in gross income if the cancellation takes place in a bankruptcy
case under the U.S. Bankruptcy Code, or if the cancellation takes place when you are
insolvent.

Insolvency occurs when, and to the extent, that liabilities exceed fair market value of assets,
determined immediately prior to the cancellation of debt.

Debt canceled when a person is insolvent is excluded from gross income, up to the amount by
which that person is insolvent.

Philip McCarthy
Attorney at Law

A taxpayer must report as income the
amount of any debt that is canceled,
unless such canceled debt is either a gift
or bequest.

TAX CONSEQUENCES OF FORGIVENESS OF DEBT

Long Answer

Federal tax law requires that a taxpayer report as income the amount of any debt that is canceled, unless such canceled
debt is either a gift or bequest. Non-business debt that is canceled is reported on 1040, line 21. Canceled business debt,
is reported on Schedule C or Schedule C-EZ (form 1040) (or on schedule F, Profit or Loss from Farming (Form 1040).

Form 1099-C, is used to inform the taxpayer of a cancellation of debt of more that $600, by a federal Government
agency, financial institution, or credit union. Form 1099-C also shows any interest canceled. Only interest that would
not have been deductible must be considered income.

If you are personally liable for a mortgage (recourse debt), and you are relieved of the mortgage when you dispose of the
property, you may realize gain or loss up to the fair market value of the property.   If mortgage discharge exceeds the fair
market value of the property it is income from discharge of indebtedness unless it qualifies for exclusion.

Canceled debt is not included in gross income if the cancellation takes place in a bankruptcy case under the U.S.
Bankruptcy Code, or if the cancellation takes place when you are insolvent.

Insolvency occurs when, and to the extent, that liabilities exceed fair market value of assets, determined immediately prior
to the cancellation of debt.

Debt canceled when a person is insolvent is excluded from gross income, up to the amount by which that person is
insolvent.

To prevent an excessive tax benefit from the debt cancellation, such excluded amount must be used to reduce certain tax
attributes, thus tax on canceled debts is in part postponed instead of being entirely forgiven.

One may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property
before reducing the other tax attributes. Generally, the amount of canceled debt is used to reduce the tax attributes in the
following order: Net operating loss, General business credit carryovers, Minimum tax credit, Capital losses, Basis, Passive
activity loss and credit carryovers, and Foreign tax credit.

The 2006 Internal Revenue Service Publication 17 (Catalogue Number 10311G) provides as follows:

CANCELED DEBT

Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled
amount in your income. You have no income for the canceled debt if it is intended as a gift to you. A debt includes any
indebtedness for which you are liable or which attaches to property you hold.

If the debt is a non-business debt, report the cancelled amount on form 1040, line 21. If it is a business debt, report the
amount on Schedule C or Schedule C-EZ (form 1040) 9or on schedule F, Profit of Loss From Farming (Form 1040), if
the debt is farm debt and you are a farmer.).

Form 1099-C. If a federal Government agency, financial institution, or credit union 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 cancelled debt is shown in
box 2.

Interest included in cancelled debt. If any interest is forgiven and included in the amount of canceled debt in box 2, the
amount of interest also will be shown in box 3. Whether or not you must include the interest portion of the canceled debt
in you income depends on whether the interest would be deductible if you paid it. . . .

Mortgage relief upon sale or other disposition.   If you are personally liable for a mortgage (recourse debt), and you are
relieved of the mortgage when you dispose of the property, you may realize gain or loss up to the fair market value of the
property.   To the extent the mortgage discharge exceeds the fair market value of the property it is income from
discharge of indebtedness unless it qualifies for exclusion under Excluded Debt, later. Report any income from discharge
of indebtedness on non-business debt that does not qualify for exclusion as other income on Form 1040, line 21.

If you are not personally liable for a mortgage (non-recourse debt), and you are relieved of the mortgage when you
dispose of the property (such as through foreclosure or repossession), that relief is included in the amount you realize.
You may have a taxable gain if the amount you realize exceeds your adjusted basis in the property. Report any gain on
non-business property as capital gain.

EXCEPTIONS

Excluded debt. Do not include a canceled debt in your gross income in the following situations.
  The debt is canceled in a bankruptcy case under title 11 of the U.S. Code. See Publication 908, Bankruptcy Tax Guide.
  The debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more
than the amount by which you insolvent. See Publication 908. . . .

The Internal Revenue Service Publication 908 (Catalogue Number 15309S, revised July 1996) Bankruptcy Tax Guide,
provides as follows:

EXCLUSIONS

Do not include a canceled debt in gross income if any of the following situations apply:

The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.
The cancellation takes place when you are insolvent. (see Insolvency exclusion, later), and the amount excluded is not
more than the amount by which you are insolvent. . . .

Insolvency exclusion. You are insolvent when, and to the extent, your liabilities exceed the fair market value of your
assets. Determine you liabilities and the fair market value of your assets immediately before the cancellation of you debt
to determine whether or not you are insolvent and the amount by which you are insolvent.

Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are
insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under
Reduction of Tax Attributes.

REDUCTION OF TAX ATTRIBUTES

If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or
she must use the excluded amount to reduce certain “tax attributes.” Tax attributes include the basis of certain assets and
the losses and credits listed next. By reducing these tax attributes, tax on canceled debts is in part postponed instead of
being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation.

Order of reduction. Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below.
However, you may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable
property before reducing the other tax attributes. This choice is discussed later.
  Net operating loss. . . .
  General business credit carryovers. . . .
  Minimum tax credit. . . .
  Capital losses. . . .
  Basis. . . .
  Passive activity loss and credit carryovers. . . .
  Foreign tax credit. . . .

For a more detailed analysis of
the tax consequences of
Forgiveness of Debt
contact me.