As I'm writing this article, we are still waiting for guidance on PPP (Paycheck Protection Program) loan forgiveness. Based on what is being discussed in Congress, there will be some big changes. Instead of writing something that will be out of date in a few weeks, I thought I'd write about a topic I've been seeing lately: debt forgiveness.
If debt is forgiven or discharged, the amount of debt you no longer have to pay is considered canceled.
In context of property, cancellation of debt occurs when the lender forecloses/repossesses the property or when the farmer abandons or transfers the property to the lender. In addition, cancellation of debt may occur when there is a modification to the mortgage.
If debt is canceled, you will have cancellation of debt income. In general, the amount of debt that is deemed canceled is treated as ordinary income. If the debt was secured by property, and the lender takes back the property, you are deemed to have sold the property back to the lender.
The tax treatment depends on the type of debt used to secure the property. If the property was subject to recourse debt, the amount realized is the fair market value of the property, and the ordinary income component from cancellation of debt is the amount of debt forgiven in excess of the fair market value of the property. For nonrecourse, the amount realized is the entire nonrecourse debt plus the amount of cash and/or fair market value of property received.
There are certain exclusions that result in cancellation of debt not treated as gross income:
-- Title 11 bankruptcy.
-- Cancellation of qualified farm debt.
-- Cancellation of qualified real property business debt.
-- Cancellation of qualified principal residency debt that was discharged by arrangement entered into prior to Jan. 1, 2021.
If one of these exclusions applies, you still must reduce certain tax attributes by the amount excluded.
I want to quickly touch upon the qualified farm debt exclusion. The exclusion applies to debt canceled related to farming when the farmer derived 50% or more of gross receipts from the trade or business of farming for a period of three years prior to the cancellation of debt. The debt has to be canceled by a "qualified" person. A qualified person can't be a related party, someone from which you purchased the property or the person who received a fee with respect to the investment in the property.
Forgiveness of debt is very complex and has several variables. It may affect a variety of business decisions such as type of debt, changes to loans and even the type of bankruptcy you file. It also affects certain tax attributes that may come as a surprise later. When an entity receives cancellation of debt income, depending on the type of entity, the impact may be on the entity or the owner level. And, if on an owner level, each owner may have a different tax consequence.
If you are expecting to default on debt and possibly receive cancellation of debt, please talk to your accountant to discuss how it may affect you.
DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Read Rod's "Ask the Taxman" column at about.dtnpf.com/tax. You may email Rod at firstname.lastname@example.org.
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