Can I Be Taxed on My Discharge of Debt?

In the current financial crisis many financial institutions may be forced to discharge debts of taxpayers. Taxpayers will be benefit (be extremely happy) by not having to repay their debtors. However, they may end up with a tax surprise.

Many taxpayers are unaware that a discharge of debt is considered (taxable) income. The taxpayer may be happy not to owe the financial institution the debt, but the may end up owing the Internal Revenue Service (IRS) tax.

Accounting to IRS regulations income from the discharge of indebtedness is includible in gross income unless it is excludable under Code Section 108. There are other provisions created by Congress besides Code Section 108 including special circumstances for Hurricane Katrina victims.

Taxpayers may exclude the forgiveness of debt income from tax in four ways. The first is exemption from including the discharge of debt in income is if the discharge is due to bankruptcy filed under Title 11 of the US Code in which the court granted.

The second method for taxpayers to exclude the forgiveness of debt income is for the taxpayer to be involvement outside of bankruptcy. The term "insolvent" refers to an surplus of the taxpayer's liabilities over the fair market value of taxpayer's assets immediately prior to discharge. The IRS is not too generous with the exclusion, for the excluded amount is limited by which the taxpayer is insolvent.

The final two exclusions are for qualified farm indebtedness and qualified real property business indebtedness. These area are more complicated as the income may be excluded from tax, however certain tax credits and basis in property may be affected.

The taxpayer will potentially need to file additional forms with their tax return. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) http://www.irs.gov/pub/irs-pdf/f982.pdf, will be filed by the taxpayer to report excluded income from the discharge of indebtedness.

Taxpayers will need to be cautious when having debt forgiven. The taxpayers may end up having poor credit and triggering income subject to tax. Determining if the forgiveness of debt is taxable or meets one of the exclusions is complicated. You should contract your tax advisor if you have any specific questions.