Cancellation of Debt If a federal agency, financial institution, or credit union cancelsor forgives a debt you owe of $600 or more, you will receive a Form1099-C, Cancellation of Debt. The amount of thecanceled debt is shown in box 2. General Rule Generally, if a debt you owe is canceled or forgiven, other than asa gift or bequest to you, you must include the canceled amount ingross income for tax purposes. A debt includes any debt for which youare liable or which attaches to property you hold. Exceptions The following discussion covers some exceptions to the general rulefor canceled debt. Price reduced after purchase.If you owe a debt to the seller for property you bought, and theseller reduces the amount you owe, generally you do not have incomefrom the reduction. Unless you are in bankruptcy or are insolvent,treat the part of the debt reduced as a purchase price adjustment andreduce your basis in the property. The rules that apply to bankruptcyand insolvency are explained under Exclusions, later. Deductible debt.You do not realize income from debt cancellation to the extent thepayment of the debt would have led to a deduction. Example.You own a business and get accounting services on credit. Later,you have trouble paying your business debts, but you are not bankruptor insolvent. Your accountant forgives part of the amount you owe forthe accounting services. How you treat the cancellation of debtdepends on your method of accounting. Cash method - You do not include the debt cancellationin income because payment for the services would have been deductibleas a business expense. Accrual method - You include the debt cancellation inincome. Under an accrual method of accounting, the expense isdeductible when you incur the liability, not when you pay thedebt. Exclusions Do not include canceled debt in income in the following situations.However, you may be required to file Form 982. See Form 982,later. The cancellation takes place in a bankruptcy case. The cancellation takes place when you are insolvent. The canceled debt is a qualified farm debt. The canceled debt is qualified real property business debt(in the case of a taxpayer other than a C corporation). Forinformation on this type of canceled debt, see chapter 5 inPublication 334. If a debt cancellation is excluded from income because it takesplace in a bankruptcy case, items (2), (3), and (4) do not apply. Ifit takes place when you are insolvent, items (3) and (4) do not applyto the extent you are insolvent. Bankruptcy and Insolvency You can exclude the cancellation or discharge of debt from incomeif you are bankrupt or to the extent you are insolvent. Bankruptcy.A bankruptcy case is a case under title 11 of the United StatesCode if you are under the jurisdiction of the court and the dischargeof the debt is granted by the court or is the result of a planapproved by the court. Do not include debt canceled in a bankruptcy case in your grossincome in the year it is canceled. Instead, you must use the amountcanceled to reduce your tax benefits, explained later underReduction of tax benefits. Insolvency.You are insolvent to the extent your liabilities are more than thefair market value of your assets immediately before the cancellationof debt. You can exclude canceled debt from gross income up to the amount bywhich you are insolvent. If the canceled debt is more than the amountby which you are insolvent and you qualify, you can apply the rulesfor qualified farm debt to the excess. Otherwise, you include theexcess in gross income. Use the amount excluded because of insolvencyto reduce any tax benefits, as explained later under Reduction oftax benefits. You must reduce the tax benefits under theinsolvency rules before applying the rules for qualified farm debt orfor qualified real property business debt. Example.You had a $10,000 debt canceled outside of bankruptcy. Immediatelybefore the cancellation, your liabilities totaled $80,000 and yourassets totaled $75,000. Since your liabilities were more than yourassets, you were insolvent to the extent of $5,000 ($80,000 -$75,000). You can exclude this amount from income. The remainingcanceled debt ($5,000) may be subject to the qualified farm debt orqualified real property business debt rules. If not, you must includeit in income. Reduction of tax benefits.If you exclude canceled debt from income in a bankruptcy case orduring insolvency, you must use the excluded debt to reduce certaintax benefits. This prevents an excessive tax benefit from thecancellation. Order of reduction.You must use the excluded canceled debt to reduce the following taxbenefits in the order listed, unless you choose to reduce the basis ofdepreciable property first, as explained later. Net operating loss (NOL). Reduce any NOL for thetax year of the debt cancellation, and then any NOL carryover to thatyear. Reduce the NOL or NOL carryover one dollar for each dollar ofexcluded canceled debt. General business credit carryover. Reduce thecredit carryover to or from the tax year of the debt cancellation.Reduce the carryover 33 1/3 cents for each dollar ofexcluded canceled debt. Minimum tax credit. Reduce the minimum tax creditavailable at the beginning of the tax year following the tax year ofthe debt cancellation. Reduce the credit 33 1/3 cents foreach dollar of excluded canceled debt. Capital loss. hotel rooms PortimaroReduce any net capital loss for thetax year of the debt cancellation, and then any capital loss carryoverto that year. Reduce the capital loss or loss carryover one dollar foreach dollar of excluded canceled debt. Basis. Reduce the basis of the property you holdat the beginning of the tax year following the tax year of the debtcancellation in the following order. Real property (except inventory) used in your trade orbusiness or held for investment that secured the canceled debt. Personal property (except inventory and accounts and notesreceivable) used in your trade or business or held for investment thatsecured the canceled debt. Other property (except inventory and accounts and notesreceivable) used in your trade or business or held forinvestment. Inventory and accounts and notes receivable. Other property. Reduce the basis one dollar for each dollar of excluded canceleddebt. However, the reduction cannot be more than the total bases ofproperty and the amount of money you hold immediately after the debtcancellation minus your total liabilities immediately after thecancellation. For allocation rules that apply to basis reductions for multiplecanceled debts, see section 1.1017-1(b)(2) of the regulations.Also see Choosing to reduce the basis of depreciable propertyfirst, later. Passive activity loss and credit carryovers.Reduce the passive activity loss and credit carryovers from thetax year of the debt cancellation. Reduce the loss carryover onedollar for each dollar of excluded canceled debt. Reduce the creditcarryover 33 1/3 cents for each dollar of excludedcanceled debt. Foreign and possession tax credits. Reduce thecredit carryover to or from the tax year of the debt cancellation.Reduce the carryover 33 1/3 cents for each dollar ofexcluded canceled debt. How to make tax benefit reductions.Always make the required reductions in tax benefits after figuringyour tax for the year of the debt cancellation. In making thereductions in (1) and (4) above, first reduce the loss for the taxyear of the debt cancellation. Then reduce any loss carryovers to thatyear in the order of the tax years from which the carryovers arose,starting with the earliest year. In making the reductions in (2) and(7) above, reduce the credit carryovers to the tax year of the debtcancellation in the order in which they are taken into account forthat year. Choosing to reduce the basis of depreciable property first.You can choose to apply any portion of the excluded canceled debtfirst to reduce the basis of your depreciable property you hold at thebeginning of the tax year following the tax year of the debtcancellation, in the following order. Depreciable real property used in your trade or business orheld for investment that secured the canceled debt. Depreciable personal property used in your trade or businessor held for investment that secured the canceled debt. Other depreciable property used in your trade or business orheld for investment. Real property held as inventory if you elect to treat it asdepreciable property on Form 982. The amount you apply cannot be more than the total adjusted basesof all the depreciable property. Depreciable property, for thispurpose, means any property subject to depreciation, but only if areduction of basis will reduce the depreciation or amortizationotherwise allowable for the period immediately following the basisreduction. You make this reduction before reducing the other tax benefitslisted earlier. If the excluded canceled debt is more than the basisreduction you can make under this choice, use the excess to reduce theother tax benefits. In figuring the limit on the basis reduction in(5), Basis, use the remaining adjusted bases of yourproperty after making this choice. See Form 982, later, for information on how to make thischoice. If you make this choice, you can revoke it only with theconsent of the IRS. Recapture of basis reductions.If you reduce the basis of property under these provisions andlater sell or otherwise dispose of the property at a gain, the part ofthe gain due to this basis reduction is taxable as ordinary incomeunder the depreciation recapture provisions. Treat any property thatis not section 1245 or section 1250 property as section 1245 property.For section 1250 property, determine the straight-line depreciationadjustments as though there were no basis reduction for debtcancellation. Sections 1245 and 1250 property and the recapture ofgain as ordinary income are explained in chapter 11. More information.For more information on debt cancellation in bankruptcy proceedingsor during insolvency, see Publication 908. Qualified Farm Debt You can exclude from income the cancellation or discharge ofqualified farm debt by a qualified person. This exclusion applies onlyif you were solvent when the debt was canceled or, if you wereinsolvent, only to the extent the canceled debt is more than theamount by which you were insolvent. Your debt is qualified farm debtif both the following requirements are met. You incurred it directly in operating a farmingbusiness. At least 50% of your total gross receipts for the 3 taxyears preceding the year of debt cancellation were from your farmingbusiness. See chapter 2for information about gross farm income andtotal gross income. Qualified person.This is a person who is actively and regularly engaged in thebusiness of lending money. A qualified person includes any federal,state, or local government, or any of their agencies or subdivisions.Therefore, these rules apply to debts discharged by the USDA. A qualified person does not include any of the following. A person related to you. A person from whom you got the property (or a person relatedto this person). A person who receives a fee from your investment in theproperty (or a person related to this person). For the definition of a related person, see Related personsunder At-Risk Amounts in Publication 925. Exclusion limit.The amount of canceled qualified farm debt you exclude from incomecannot be more than the sum of your adjusted tax benefits and thetotal adjusted bases of the qualified property you hold at thebeginning of the tax year following the tax year of the debtcancellation. Figure this limit after taking into account anyreduction of tax benefits because of debt canceled during insolvency. If the canceled debt is more than this limit, you must include thedifference in gross income. Adjusted tax benefits.Adjusted tax benefits means the sum of the following items. Any net operating loss (NOL) for the tax year of the debtcancellation and any NOL carryover to that year. Any general business credit carryover to or from the year ofthe debt cancellation, multiplied by 3. Any minimum tax credit available at the beginning of the taxyear following the tax year of the debt cancellation, multiplied by3. Any net capital loss for the tax year of the debtcancellation and any capital loss carryover to that year. Any passive activity loss and credit carryovers from the taxyear of the debt cancellation. Any credit carryover is multiplied by3. Any foreign and possession tax credit carryovers to or fromthe tax year of the debt cancellation, multiplied by 3. You multiply the credits by 3 to make them comparable with thededuction benefits. Qualified property.This is any property you use or hold for use in your trade orbusiness or for the production of income. Reduction of tax benefits.If you exclude canceled debt from income under the qualified farmdebt rules, you must use the excluded debt to reduce tax benefits. (Ifyou also excluded canceled debt under the insolvency rules, you reducethe amount of the tax benefits remaining after reduction for theexclusion allowed under those rules.) You generally must follow thereduction rules previously explained under Bankruptcy andInsolvency. However, do not follow the rules in item (5),Basis. Instead, follow the special rules explained next. Special rules for reducing the basis of property.You must use special rules to reduce the basis of property forexcluded canceled qualified farm debt. Under these special rules, youonly reduce the basis of qualified property (defined earlier) in thefollowing order. Depreciable qualified property. You may choose on Form 982to treat real property held as inventory as depreciableproperty. Land that is qualified property and is used or held for usein your farming business. Other qualified property. Form 982 Use Form 982 to show the amounts of canceled debt excluded fromincome and the reduction of tax benefits in the order listed on theform. Also use it if you are making the choice to apply the excludedcanceled debt to reduce the basis of depreciable property beforereducing tax benefits. You make this choice by showing the amount youchoose to apply on line 5 of the form. When to file.You must file Form 982 with your timely filed income tax return(including extensions) for the tax year in which the cancellation ofdebt occurred. If you timely filed your return for the year withoutmaking the choice to apply the excluded canceled debt to reduce thebasis of depreciable property first, you can still make the choice byfiling an amended return within six months of the due date of thereturn (excluding extensions). Attach Form 982 to the amended returnand write "Filed pursuant to section 301.9100-2" at the topof the form. File the amended return at the same address you filed theoriginal return.