In the COVID-19-ravaged economy, debts can pile up beyond a borrower’s ability to repay. Lenders sometimes may be willing to forgive (or cancel) debts that are owed by certain borrowers. While debt forgiveness can help struggling borrowers survive financially, it can sometimes trigger negative tax consequences. Here’s what borrowers need to know about the tax implications of so-called “cancellation of debt” (COD) income.
General Tax Rule
When a lender forgives part or all of a debt, it results in COD income. The general federal income tax rule is that COD income counts as taxable gross income. For the year when COD income occurs, the lender is supposed to report the forgiven amount to the borrower and to the IRS on Form 1099-C, Cancellation of Debt.
Fortunately, there are several favorable federal income tax exceptions to the general rule that COD income is taxable. Here are seven exceptions that are likely to help struggling individual borrowers.
1. Bankruptcy Exception
If the borrower’s debt is forgiven in a Title 11 bankruptcy proceeding, the COD income is exempt from federal income taxation. Title 11 includes bankruptcy filings under:
- Chapter 7 (liquidations),
- Chapter 11 (reorganizations), and
- Chapter 13 (wage earner filings).
Legislation enacted in 2005 made it more difficult for individuals to file under Chapter 7 and be completely exonerated from unsecured debts, such as credit card balances. However, debts incurred by individuals are still forgiven in some Chapter 7 proceedings, as well as in some Chapter 11 and Chapter 13 proceedings. When that happens, the resulting COD income is free from federal income tax.
2. Insolvency Exception
A borrower is insolvent when the individual’s debts exceed the fair market value of his or her assets. When borrowers are insolvent immediately before debt cancellation occurs, the resulting COD income is exempt from federal income taxation to the extent of that insolvency.
However, when the debt cancellation effectively makes the borrower solvent — because assets now exceed debts — the COD income is taxable to the extent the borrower is made solvent. Any remaining COD income is federal-income-tax-free under the insolvency exception.
3. Home Mortgage Exception
An exception for forgiven home mortgage debt was enacted years ago and then repeatedly extended. The most-recent extension covers qualifying cancellations of home mortgage debt that occur through 2020. Whether the exception will be extended beyond this year depends on Congress.
This exception allows an individual to have up to $2 million of federal-income-tax-free COD income from forgiven qualified principal residence debt. This means debt that 1) was used to acquire, build or improve your principal residence, and 2) is secured by that residence.
Refinanced debt can qualify for this exception to the extent that it replaces debt used to acquire, build or improve your principal residence. You must reduce the tax basis of your residence (but not below zero) by the amount of COD income that you’re allowed to treat as federal-income-tax-free under this exception. You don’t need to be bankrupt or insolvent to take advantage of this exception.
Important: This exception isn’t available for COD income from forgiven second mortgages, home equity lines of credit, vacation home mortgages or rental property mortgages.
4. Deductible Interest Exception
To the extent COD income consists of unpaid interest that was added to your loan principal and then forgiven, any forgiven interest that you could have deducted — if you had paid it — is exempt from federal income tax. This exception often comes into play with forgiven principal residence mortgage interest, vacation home mortgage interest and rental property mortgage interest.
5. Seller-Financed Debt Exception
Seller-financed debt arises when a buyer finances all or part of a property purchase with a private loan from the previous owner. When seller-financed debt is forgiven, the resulting COD income is exempt from federal income taxation. However, you must reduce your tax basis in the property by the amount of COD income that’s treated as federal-income-tax-free under this exception.
6. PPP Loan Exception
The Coronavirus Aid, Relief and Economic Security (CARES) Act authorized Paycheck Protection Program (PPP) loans to help small businesses, including sole proprietorships, partnerships, LLCs and S corporations, survive COVID-19 economic fallout. The PPP loan program is supervised by the Small Business Association (SBA). PPP loans can be forgiven if certain criteria are met, and forgiven amounts are excluded from the borrower’s gross income for federal tax purposes.
The rules for forgiveness of PPP loans have been a moving target, and future legislation may keep the target moving. Here’s what we currently know after the Paycheck Protection Program Flexibility Act of 2020 (PPPFA) became law on June 5:
- According to the original CARES Act rules for PPP loans, no forgiveness was allowed unless the borrower spent at least 75% of loan proceeds on payroll expenses. The PPPFA lowered the threshold to 60%.
- The PPPFA gives borrowers up to 24 weeks to use PPP loan proceeds for purposes that will result in loan forgiveness, versus only eight weeks under the original CARES Act rules.
- Borrowers now have up to five years to repay PPP loans that aren’t forgiven, versus only 24 months under the original CARES Act. This favorable change automatically applies to loans made on or after June 5, 2020. For earlier loans, borrowers and lenders can agree to modify the loan terms to allow the five-year repayment deal.
The PPPFA included other liberalizations to the original CARES Act rules. Contact your tax advisor for details.
Important: The SBA has released two PPP loan forgiveness applications (a short form for eligible borrowers and a long form for others). Some PPP lenders aren’t currently accepting debt forgiveness applications. Why? Because this issue has proven to be a moving target. Your tax advisor can keep you updated on when to submit a PPP loan forgiveness application.
7. Student Loan Exceptions
COD income from certain cancellations of student loan debt is federal-income-tax-free. However, cancellation must be contingent on the student working for a certain time period in certain professions for certain classes of employers. For 2018 through 2025, the Tax Cuts and Jobs Act (TCJA) expanded the tax-free exception to cover certain student loan debt cancellations due to the student’s death or disability.
Additionally, under the Defense to Repayment procedure, the U.S. Department of Education is required to discharge a federal direct loan if a student-borrower establishes, as a defense against repayment, that the school’s actions would give rise to a cause of action against the school under applicable state law. Federal Family Education Loans can also be discharged under this procedure if certain additional requirements are met.
There’s no statutory rule that allows tax-free treatment for COD income from loans that are discharged under the Defense to Repayment procedure. But the student-borrower may be able to exclude COD income amounts under other tax-law exceptions (such as the bankruptcy or insolvency exception) or under non-statutory exceptions that are sometimes granted by the IRS.
Important: The CARES Act suspended all payments, interest and collections for government-held federal student loans through September 30, 2020. In an executive action issued on August 8, 2020, President Trump extended the suspension through December 31, 2020.
The issue of student loan forgiveness may also prove to be a moving target. Future COVID-19 relief legislation may include good news for student loan borrowers. Your tax advisor can keep you posted on developments.
For More Information
This article covers the most-common exceptions to the general rule that COD income is taxable. There are other lesser-known exceptions that are beyond the scope of this article. We offer business tax planning services along with personal tax services. Contact us for more information regarding the tax treatment of COD income in various circumstances.