Publication 4681 (2012), Canceled Debts, Foreclosures, Repossessions, and Abandonments

(for Individuals)

For use in preparing 2012 Returns

Table of Contents

Exceptions

There are several exceptions to the inclusion of canceled debt in income. These exceptions apply before the exclusions discussed later and do not require you to reduce your tax attributes.

Gifts, Bequests, Devises, and Inheritances

In most cases, you do not have income from canceled debt if the cancellation or forgiveness of the debt is a gift, bequest, devise, or inheritance.

Student Loans

Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers.

If your student loan is canceled as the result of this type of provision, the cancellation of this debt is not included in your gross income. To qualify for this treatment, the loan must have been made by:

  1. The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof,

  2. A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or

  3. An educational institution (defined later):

    1. Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or

    2. As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization (defined later).

A loan to refinance a qualified student loan also will qualify if it was made by an educational institution or a tax-exempt section 501(a) organization under its program designed as described in (3)(b) above.

Exception.   Generally, the cancellation of a student loan made by an educational institution because of services you performed for that institution or another organization that provided funds for the loan must be included in the gross income on your tax return.

Education loan repayment assistance.   Education loan repayments made to you by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act are not taxable if you agree to provide primary health services in health professional shortage areas.

  Amounts you received after 2008 under any other state loan repayment or loan forgiveness program also are not taxable. The program must be intended to increase the availability of health care services in underserved areas or areas with a shortage of health professionals.

Educational institution.   An educational institution is an organization with a regular faculty and curriculum and a regularly enrolled body of students in attendance at the place where the educational activities are carried on.

Section 501(c)(3) organization.    A section 501(c)(3) organization is any corporation, community chest, fund, or foundation organized and operated exclusively for one or more of the following purposes.

  • Charitable.

  • Educational.

  • Fostering national or international amateur sports competition (but only if none of the organization's activities involve providing athletic facilities or equipment).

  • Literary.

  • Preventing cruelty to children or animals.

  • Religious.

  • Scientific.

  • Testing for public safety.

Deductible Debt

If you use the cash method of accounting, you do not realize income from the cancellation of debt if the payment of the debt would have been a deductible expense. This exception applies before the price reduction exception discussed next.

Example.

You get accounting services for your farm on credit. Later, you have trouble paying your farm debts and your accountant forgives part of the amount you owe for the accounting services. How you treat the canceled debt depends on your method of accounting.

  • Cash method. You do not include the canceled debt in income because payment of the debt would have been deductible as a business expense.

  • Accrual method. Unless another exception or exclusion applies, you must include the canceled debt in ordinary income because the expense was deductible when you incurred the debt.

Price Reduced After Purchase

If debt you owe the seller for the purchase of property is reduced by the seller at a time when you are not insolvent and the reduction does not occur in a title 11 bankruptcy case, the reduction does not result in cancellation of debt income. However, you must reduce your basis in the property by the amount of the reduction of your debt to the seller. The rules that apply to bankruptcy and insolvency are explained in the next section, Exclusions .

Home Affordable Modification Program

Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program are not taxable.

Exclusions

After you have applied any exceptions to the general rule that a canceled debt is included in your income, there are several reasons why you might still be able to exclude a canceled debt from your income. These exclusions are explained next. If a canceled debt is excluded from your income, that means it is nontaxable. In most cases, however, if you exclude canceled debt from income under one of these provisions, you must also reduce your tax attributes (certain credits, losses, and basis of assets) as explained later under Reduction of Tax Attributes.

Reacquisition of business debt. If you made an election under section 108(i) of the Internal Revenue Code to defer and ratably include income from the cancellation of business debt arising from the reacquisition of certain business debt repurchased in 2009 and 2010, you cannot exclude that income, for the tax year of the election or any later tax year, based on a title 11 bankruptcy case, insolvency, qualified farm indebtedness, or qualified real property business indebtedness. For more details, see section 108(i) of the Internal Revenue Code and Revenue Procedure 2009-37, 2009-36 I.R.B. 309, available at www.irs.gov/irb/2009-36_IRB/ar07.html.

Bankruptcy

Debt canceled in a title 11 bankruptcy case is not included in your income. A title 11 bankruptcy case is a case under title 11 of the United States Code (including all chapters in title 11 such as chapters 7, 11, and 13), but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.

How to report the bankruptcy exclusion.   To show that your debt was canceled in a bankruptcy case and is excluded from income, attach Form 982 to your federal income tax return and check the box on line 1a. Lines 1b through 1e do not apply to a cancellation that occurs in a title 11 bankruptcy case. Enter the total amount of debt canceled in your title 11 bankruptcy case on line 2. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

Insolvency

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:

  • The entire amount of recourse debts,

  • The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and

  • The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.

You can use the worksheet on page 6 to help calculate the extent that you were insolvent immediately before the cancellation.

Note.

This exclusion does not apply to a cancellation of debt that occurs in a title 11 bankruptcy case. It also does not apply if the debt is qualified principal residence indebtedness (defined in this section under Qualified Principal Residence Indebtedness, later) unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion.

How to report the insolvency exclusion.   To show that you are excluding canceled debt from income under the insolvency exclusion, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You can use the worksheet on page 6 to help calculate the extent that you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

Example 1—amount of insolvency more than canceled debt.

In 2012, Greg was released from his obligation to pay his personal credit card debt in the amount of $5,000. Greg received a 2012 Form 1099-C from his credit card lender showing the entire amount of discharged debt of $5,000 in box 2. None of the exceptions to the general rule that canceled debt is included in income apply. Greg uses the insolvency worksheet to determine that his total liabilities immediately before the cancellation were $15,000 and the FMV of his total assets immediately before the cancellation was $7,000. This means that immediately before the cancellation, Greg was insolvent to the extent of $8,000 ($15,000 total liabilities minus $7,000 FMV of his total assets). Because the amount by which Greg was insolvent immediately before the cancellation was more than the amount of his debt canceled, Greg can exclude the entire $5,000 canceled debt from income.

When completing his tax return, Greg checks the box on line 1b of Form 982 and enters $5,000 on line 2. Greg completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Greg does not include any of the $5,000 canceled debt on line 21 of his Form 1040. None of the canceled debt is included in his income.

Example 2—amount of insolvency less than canceled debt.

The facts are the same as in Example 1 except that Greg's total liabilities immediately before the cancellation were $10,000 and the FMV of his total assets immediately before the cancellation was $7,000. In this case, Greg is insolvent to the extent of $3,000 ($10,000 total liabilities minus $7,000 FMV of his total assets) immediately before the cancellation. Because the amount of the canceled debt was more than the amount by which Greg was insolvent immediately before the cancellation, Greg can exclude only $3,000 of the $5,000 canceled debt from income under the insolvency exclusion.

Greg checks the box on line 1b of Form 982 and includes $3,000 on line 2. Also, Greg completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Additionally, Greg must include $2,000 of canceled debt on line 21 of his Form 1040 (unless another exclusion applies).

Example 3—joint debt and separate returns.

In 2012, James and his wife Robin were released from their obligation to pay a debt of $10,000 for which they were jointly and severally liable. None of the exceptions to the general rule that canceled debt is included in income apply. They incurred the debt (originally $12,000) to finance James's purchase of a $9,000 motorcycle and Robin's purchase of a laptop computer and software for personal use for $3,000. They each received a 2012 Form 1099-C from the bank showing the entire canceled debt of $10,000 in box 2. Based on the use of the loan proceeds, they agreed that James was responsible for 75% of the debt and Robin was responsible for the remaining 25%. Therefore, James's share of the debt is $7,500 (75% of $10,000), and Robin's share is $2,500 (25% of $10,000). By completing the insolvency worksheet, James determines that, immediately before the cancellation of the debt, he was insolvent to the extent of $5,000 ($15,000 total liabilities minus $10,000 FMV of his total assets). He can exclude $5,000 of his $7,500 canceled debt. Robin completes a separate insolvency worksheet and determines she was insolvent to the extent of $4,000 ($9,000 total liabilities minus $5,000 FMV of her total assets). She can exclude her entire canceled debt of $2,500.

When completing his separate tax return, James checks the box on line 1b of Form 982 and enters $5,000 on line 2. He completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. He must include the remaining $2,500 ($7,500 − $5,000) of canceled debt on line 21 of his Form 1040 (unless another exclusion applies).

When completing her return, Robin checks the box on line 1b of Form 982 and enters $2,500 on line 2. She completes Part II to reduce her tax attributes as explained under Reduction of Tax Attributes, later. She does not include any of the canceled debt on line 21 of her Form 1040. None of the canceled debt has to be included in her income.

Qualified Farm Indebtedness

You can exclude canceled farm debt from income on your 2012 return if all of the following apply.

  • The debt was incurred directly in connection with your operation of the trade or business of farming.

  • 50% or more of your total gross receipts for 2009, 2010, and 2011 were from the trade or business of farming.

  • The cancellation was made by a qualified person. A qualified person is an individual, organization, partnership, association, corporation, etc., who is actively and regularly engaged in the business of lending money. A qualified person also includes any federal, state, or local government or agency or instrumentality thereof. The United States Department of Agriculture is a qualified person. A qualified person cannot be related to you, cannot be the person from whom you acquired the property (or a person related to this person), and cannot be a person who receives a fee due to your investment in the property (or a person related to this person).

For the definition of the term “related person,” see Related persons under At-Risk Amounts in Publication 925, Passive Activity and At-Risk Rules.

Note.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case or to the extent you were insolvent immediately before the cancellation. If qualified farm debt is canceled in a title 11 case, you must apply the bankruptcy exclusion rather than the exclusion for canceled qualified farm debt. If you were insolvent immediately before the cancellation of qualified farm debt, you must apply the insolvency exclusion before applying the exclusion for canceled qualified farm debt.

Exclusion limit.   The amount of canceled qualified farm debt you can exclude from income under this exclusion is limited. It cannot be more than the sum of:

  • Your adjusted tax attributes, and

  • The total adjusted bases of qualified property you held at the beginning of 2012.

If you excluded canceled debt under the insolvency exclusion, the adjusted basis of any qualified property and adjusted tax attributes are determined after any reduction of tax attributes required under the insolvency exclusion.

  Any canceled qualified farm debt that is more than this limit must be included in your income.

  For more information about the basis of property, see Publication 551.

Adjusted tax attributes.   Adjusted tax attributes means the sum of the following items.

  1. Any net operating loss (NOL) for 2012 and any NOL carryover to 2012.

  2. Any net capital loss for 2012 and any capital loss carryover to 2012.

  3. Any passive activity loss carryover from 2012.

  4. Three times the sum of any:

    1. General business credit carryover to or from 2012,

    2. Minimum tax credit available as of the beginning of 2013,

    3. Foreign tax credit carryover to or from 2012, and

    4. Passive activity credit carryover from 2012.

Qualified property.   This is any property you use or hold for use in your trade or business or for the production of income.

How to report the qualified farm indebtedness exclusion.   To show that all or part of your canceled debt is excluded from income because it is qualified farm debt, check the box on line 1c of Form 982 and attach it to your Form 1040. On line 2 of Form 982, include the amount of the qualified farm debt canceled, but not more than the exclusion limit (explained earlier). You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

Example 1.

In 2012, Chuck was released from his obligation to pay a $10,000 debt that was incurred directly in connection with his trade or business of farming. Chuck received a Form 1099-C from the qualified lender showing discharged debt of $10,000 in box 2. For his 2009, 2010, and 2011 tax years, at least 50% of Chuck's total gross receipts were from the trade or business of farming. Chuck's adjusted tax attributes are $5,000 and Chuck has $3,000 total adjusted bases in qualified property at the beginning of 2013. Chuck had no other debt canceled during 2012 and no other exception or exclusion relating to canceled debt income applies.

Chuck can exclude $8,000 ($5,000 of adjusted tax attributes plus $3,000 total adjusted bases in qualified property at the beginning of 2013) of the $10,000 canceled debt from income. Chuck checks the box on line 1c of Form 982 and enters $8,000 on line 2. Also, Chuck completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. The remaining $2,000 of canceled qualified farm debt is included in Chuck's income on Schedule F, line 8.

Example 2.

On March 1, 2012, Bob was released from his obligation to pay a $10,000 business credit card debt that was used directly in connection with his farming business. For his 2009, 2010, and 2011 tax years, at least 50% of Bob's total gross receipts were from the trade or business of farming. Bob received a 2012 Form 1099-C from the qualified lender showing discharged debt of $10,000 in box 2. The FMV of Bob's total assets on March 1, 2012, (immediately before the cancellation of the credit card debt) was $7,000 and Bob's total liabilities at that time were $11,000. Bob's adjusted tax attributes (a 2012 NOL) are $7,000 and Bob has $4,000 total adjusted bases in qualified property at the beginning of 2013.

Bob qualifies to exclude $4,000 of the canceled debt under the insolvency exclusion because he is insolvent to the extent of $4,000 immediately before the cancellation ($11,000 total liabilities minus $7,000 FMV of total assets). Bob must reduce his tax attributes under the insolvency rules before applying the rules for qualified farm debt. Bob also qualifies to exclude the remaining $6,000 of canceled qualified farm debt. The limit on Bob's exclusion from income of canceled qualified farm debt is $7,000, the sum of his adjusted tax attributes of $3,000 (the $7,000 NOL minus the $4,000 reduction of tax attributes required because of the $4,000 exclusion of canceled debt under the insolvency exclusion) plus $4,000 (Bob's total adjusted bases in qualified property at the beginning of 2013).

Bob checks the boxes on lines 1b and 1c of Form 982 and enters $10,000 on line 2. Bob completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Bob does not include any of his canceled debt in income.

Example 3.

The facts are the same as in Example 2 except that immediately before the cancellation Bob was insolvent to the extent of the full $10,000 canceled debt. Because the exclusion for qualified farm debt does not apply to the extent that you were insolvent immediately before the cancellation, Bob checks only the box on line 1b of Form 982 and enters $10,000 on line 2. Bob completes Part II to reduce his tax attributes based on the insolvency exclusion as explained under Reduction of Tax Attributes, later. Bob does not include any of the canceled debt in income.

Qualified Real Property Business Indebtedness

You can elect to exclude canceled qualified real property business indebtedness from income. Qualified real property business indebtedness is debt (other than qualified farm debt) that meets all of the following conditions.

  1. It was incurred or assumed in connection with real property used in a trade or business.

  2. It is secured by that real property.

  3. It was incurred or assumed:

    1. Before 1993, or

    2. After 1992, if the debt is either (i) qualified acquisition indebtedness (defined next), or (ii) debt incurred to refinance qualified real property business debt incurred or assumed before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced).

  4. It is debt to which you elect to apply these rules.

Qualified property.   This is any property you use or hold for use in your trade or business or for the production of income, including rental income.

Insolvency Worksheet

Date debt was canceled (mm/dd/yy)  
Part I. Total liabilities immediately before the cancellation (do not include the same liability in more than one category)
Liabilities (debts) Amount Owed 
Immediately Before the 
Cancellation
1. Credit card debt $
2. Mortgage(s) on real property (including first and second mortgages and home equity loans) (mortgage(s) can be on personal residence, any additional residence, or property held for investment or used in a trade or business) $
3. Car and other vehicle loans $
4. Medical bills owed $
5. Student loans $
6. Accrued or past-due mortgage interest $
7. Accrued or past-due real estate taxes $
8. Accrued or past-due utilities (water, gas, electric) $
9. Accrued or past-due child care costs $
10. Federal or state income taxes remaining due (for prior tax years) $
11. Judgments $
12. Business debts (including those owed as a sole proprietor or partner) $
13. Margin debt on stocks and other debt to purchase or secured by investment assets other than real property $
14. Other liabilities (debts) not included above $
15. Total liabilities immediately before the cancellation. Add lines 1 through 14. $
Part II. Fair market value (FMV) of assets owned immediately before the cancellation (do not include the FMV of the same asset in more than one category)
Assets FMV Immediately Before  
the Cancellation
16. Cash and bank account balances $
17. Homes (including the value of land) (can be main home, any additional home, or property held for investment or used in a trade or business) $
18. Cars and other vehicles $
19. Computers $
20. Household goods and furnishings (for example, appliances, electronics, furniture, etc.) $
21. Tools $
22. Jewelry $
23. Clothing $
24. Books $
25. Stocks and bonds $
26. Investments in coins, stamps, paintings, or other collectibles $
27. Firearms, sports, photographic, and other hobby equipment $
28. Interest in retirement accounts (IRA accounts, 401(k) accounts, and other retirement accounts) $
29. Interest in a pension plan $
30. Interest in education accounts $
31. Cash value of life insurance $
32. Security deposits with landlords, utilities, and others $
33. Interests in partnerships $
34. Value of investment in a business $
35. Other investments (for example, annuity contracts, guaranteed investment contracts, mutual funds, commodity accounts, interests in hedge funds, and options) $
36. Other assets not included above $
37. FMV of total assets immediately before the cancellation. Add lines 16 through 36. $
Part III. Insolvency
38. Amount of Insolvency. Subtract line 37 from line 15. If zero or less, you are not insolvent. $
Definition of qualified acquisition indebtedness.   Qualified acquisition indebtedness is:

  • Debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property that is used in a trade or business and secures the debt, or

  • Debt resulting from the refinancing of qualified acquisition indebtedness, to the extent the amount of the debt does not exceed the amount of debt being refinanced.

Note.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case or to the extent you were insolvent immediately before the cancellation. If qualified real property business debt is canceled in a title 11 bankruptcy case, you must apply the bankruptcy exclusion rather than the exclusion for canceled qualified real property business debt. If you were insolvent immediately before the cancellation of qualified real property business debt, you must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business debt.

Exclusion limit.   The amount of canceled qualified real property business debt you can exclude from income is limited under this exclusion to the excess (if any) of:

  • The outstanding principal amount of the qualified real property business debt (immediately before the cancellation), over

  • The FMV (immediately before the cancellation) of the business real property securing the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property (immediately before the cancellation).

  In addition to this limit, a second overall limit applies. The amount of canceled qualified real property business debt you can exclude from income cannot be more than the total adjusted bases of depreciable real property you held immediately before the cancellation of the qualified real property business indebtedness (other than depreciable real property acquired in contemplation of the cancellation). When figuring this overall limit, use the adjusted basis of the depreciable real property after any reductions in basis required because of the exclusion of debt canceled under the bankruptcy, insolvency, or farm debt provisions described in this publication.

  For more information about the basis of property, see Publication 551.

How to elect the qualified real property business debt exclusion.   You must make an election to exclude canceled qualified real property business debt from gross income. The election must be made on a timely filed (including extensions) federal income tax return for 2012 and can be revoked only with IRS consent. The election is made by completing Form 982 in accordance with its instructions. Attach Form 982 to your federal income tax return for 2012 and check the box on line 1d. Include the amount of canceled qualified real property business debt (but not more than the amount of the exclusion limit, explained above) on line 2 of Form 982. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, later.

  If you timely filed your tax return without making this election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Enter “Filed pursuant to section 301.9100-2” on the amended return and file it at the same place you filed the original return.

Example.

In 2007, Curt bought a retail store for use in a business he operated as a sole proprietorship. Curt made a $20,000 down payment and financed the remaining $200,000 of the purchase price with a bank loan. The bank loan was a recourse loan and was secured by the property. Curt used the property in his business continuously since he bought it. He had no other debt secured by that depreciable real property. In addition to the retail store, Curt owned depreciable equipment and furniture with an adjusted basis of $50,000.

Curt's business encountered financial difficulties in 2012. On September 26, 2012, the bank financing the retail store loan entered into a workout agreement with Curt under which it canceled $20,000 of the debt. Immediately before the cancellation, the outstanding principal balance on the retail store loan was $185,000, the FMV of the store was $165,000, and the adjusted basis was $210,000 ($220,000 cost minus $10,000 accumulated depreciation).

The bank sent him a 2012 Form 1099-C showing discharged debt of $20,000 in box 2. Curt had no tax attributes other than basis to reduce and did not qualify for any exception or exclusion other than the qualified real property business debt exclusion.

Curt elects to apply the qualified real property business debt exclusion to the canceled debt. The amount of canceled qualified real property business debt that he can exclude from income is limited to $20,000 (the excess of the $185,000 outstanding principal amount of his qualified real property business debt immediately before the cancellation over the $165,000 FMV of the business real property securing the debt). Curt's exclusion is also subject to a $210,000 limit equal to the adjusted basis of depreciable real property he held immediately before the cancellation.

Thus, Curt can exclude the entire $20,000 of canceled qualified real property business debt from income. Curt checks the box on line 1d of Form 982 and enters $20,000 on line 2. Curt must also use line 4 of Form 982 to reduce his basis in depreciable real property by the $20,000 of canceled qualified real property business debt excluded from his income as explained under Reduction of Tax Attributes, later.

Qualified Principal Residence Indebtedness

You can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing.

Example 1.

In 2006, Becky bought a main home for $315,000. She took out a $300,000 mortgage loan to buy the home and made a down payment of $15,000. The loan was secured by the home. In 2007, Becky took out a second mortgage loan in the amount of $50,000 that she used to add a garage to her home.

In 2012, when the outstanding principal of her first and second mortgage loans was $325,000, Becky refinanced the two loans into one loan in the amount of $400,000. The FMV of the home at the time of the refinancing was $430,000. She used the additional $75,000 debt proceeds ($400,000 new mortgage loan minus $325,000 outstanding principal balances of her first and second mortgage loans immediately before the refinancing) to pay off personal credit cards and to pay college tuition for her daughter.

After the refinancing, Becky's qualified principal residence indebtedness is $325,000 because the debt resulting from the refinancing is qualified principal residence indebtedness only to the extent it is not more than the old mortgage principal just before the refinancing.

Example 2.

In 2005, Steve acquired his main home for $200,000, subject to a mortgage of $175,000. In 2006, he took out a home equity loan for $10,000, secured by his main home, which he used to pay off personal credit cards.

In 2007, when the outstanding principal on his mortgage was $170,000 and the outstanding principal on his home equity loan was $9,000, he refinanced the two loans into one loan in the amount of $200,000. The FMV of the home at the time of refinancing was $210,000. He used the additional $21,000 ($200,000 new mortgage loan minus $179,000 outstanding principal balances on the mortgage and home equity loan) to cover medical expenses.

After refinancing, Steve's qualified principal residence indebtedness is $170,000 because the debt resulting from the refinancing is qualified principal residence indebtedness only to the extent it refinances debt that had been secured by the main home and was used to buy, build, or substantially improve the main home.

Main home.   Your main home is the one in which you live most of the time. You can have only one main home at any one time.

Note.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case. If qualified principal residence indebtedness is canceled in a title 11 bankruptcy case, you must apply the bankruptcy exclusion rather than the exclusion for qualified principal residence indebtedness. If you were insolvent immediately before the cancellation, you can elect to apply the insolvency exclusion (as explained under Insolvency, earlier) instead of applying the qualified principal residence indebtedness exclusion. To do this, check the box on line 1b of Form 982 instead of the box on line 1e.

Exclusion limit.   The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). You cannot exclude canceled qualified principal residence indebtedness from income if the cancellation was for services performed for the lender or on account of any other factor not directly related to a decline in the value of your home or to your financial condition.

Ordering rule.   If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount canceled is more than the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another exclusion.

Example.

Ken incurred recourse debt of $800,000 when he bought his main home for $880,000. When the FMV of the property was $1,000,000, Ken refinanced the debt for $850,000. At the time of the refinancing, the principal balance of the original mortgage loan was $740,000. Ken used the $110,000 he obtained from the refinancing ($850,000 minus $740,000) to pay off his credit cards and to buy a new car.

About 2 years after the refinancing, Ken lost his job and was unable to get another job paying a comparable salary. Ken's home had declined in value to between $700,000 and $750,000. Based on Ken's circumstances, the lender agreed to allow a short sale of the property for $735,000 and to cancel the remaining $115,000 of the $850,000 debt. Under the ordering rule, Ken can exclude only $5,000 of the canceled debt from his income under the exclusion for canceled qualified principal residence indebtedness ($115,000 canceled debt minus the $110,000 amount of the debt that was not qualified principal residence indebtedness). Ken must include the remaining $110,000 of canceled debt in income on line 21 of his Form 1040 (unless another exclusion applies).

How to report the qualified principal residence indebtedness exclusion.   To show that all or part of your canceled debt is excluded from income because it is qualified principal residence indebtedness, attach Form 982 to your federal income tax return and check the box on line 1e. On line 2 of Form 982, include the amount of canceled qualified principal residence indebtedness, but not more than the amount of the exclusion limit (explained earlier). If you continue to own your home after a cancellation of qualified principal residence indebtedness, you must reduce your basis in the home as explained under Reduction of Tax Attributes, next.

Reduction of Tax Attributes

If you exclude canceled debt from income, you must reduce certain tax attributes (but not below zero) by the amount excluded. Use Part II of Form 982 to reduce your tax attributes. The order in which the tax attributes are reduced depends on the reason the canceled debt was excluded from income. If the total amount of canceled debt excluded from income (line 2 of Form 982) was more than your total tax attributes, the total reduction of tax attributes in Part II of Form 982 will be less than the amount on  
line 2.

Qualified Principal Residence Indebtedness

If you exclude canceled qualified principal residence indebtedness from income and you continue to own the home after the cancellation, you must reduce the basis of the home (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Enter the amount of the basis reduction on line 10b of Form 982.

For more details on determining the basis of your main home, see Publication 523.

Bankruptcy and Insolvency

No tax attributes other than basis of personal-use property.   If the canceled debt you are excluding is a debt other than qualified principal residence indebtedness (such as a car loan or credit card debt) and you have no tax attributes other than the adjusted basis of personal-use property you own (see the list of seven tax attributes, later), you must reduce the basis of the personal-use property you held at the beginning of 2013 (in proportion to adjusted basis). Personal-use property is any property that is not used in your trade or business nor held for investment (such as your home, home furnishings, and car). Include on line 10a of Form 982 the smallest of:

  • The bases of your personal-use property held at the beginning of 2013,

  • The amount of canceled nonbusiness debt (other than qualified principal residence indebtedness) that you are excluding from income on line 2 of Form 982, or

  • The excess of the total bases of the property and the amount of money you held immediately after the cancellation over your total liabilities immediately after the cancellation.

  For general information about the basis of property, see Publication 551.

Example.

In 2009, Mya bought a car for personal use. The cost of the car was $12,000. Mya put down $2,000 and took out a loan of $10,000 to buy the car. The loan was a recourse loan, meaning that Mya was personally liable for the full amount of the debt.

On December 7, 2012, when the balance of the loan was $8,500, the lender repossessed and sold the car because Mya had stopped making payments on the loan. The FMV of the car was $7,000 at the time the lender repossessed and sold it. The lender applied the $7,000 it received on the sale of the car against Mya's loan and forgave the remaining loan balance of $1,500 ($8,500 outstanding balance immediately before the repossession minus the $7,000 FMV of the car).

Mya's only other assets at the time of the cancellation are the furniture in her apartment which has a cost basis of $5,000 and an FMV of $3,000, jewelry with a basis of $500 and an FMV of $1,000, and a $600 balance in her savings account. Thus, the FMV of Mya's total assets immediately before the cancellation was $11,600 ($7,000 car plus $3,000 furniture plus $1,000 jewelry plus $600 savings). Mya also had an outstanding student loan balance of $6,000 immediately before the cancellation, bringing her total liabilities at that time to $14,500 ($8,500 balance on car loan plus $6,000 student loan balance). Other than the car, which was repossessed, Mya held all of these assets at the beginning of 2013. The FMV and bases of the assets remained the same at the beginning of 2013.

Mya received a 2012 Form 1099-C showing $1,500 in box 2 (amount of debt canceled) and $7,000 in box 7 (FMV of the property). Mya can exclude all $1,500 of canceled debt from income because at the time of the cancellation, she was insolvent to the extent of $2,900 ($14,500 of total liabilities immediately before the cancellation minus $11,600 FMV of total assets at that time).

Mya checks box 1b on Form 982 and enters $1,500 on line 2. She enters $100 on line 10a (the smallest of: (a) the $5,500 bases of her personal-use property held at the beginning of 2013 ($5,000 furniture plus $500 jewelry), (b) the $1,500 nonbusiness debt she is excluding from income on line 2 of Form 982, or (c) the $100 excess of the total bases of the property and the amount of money Mya held immediately after the cancellation over her total liabilities at that time ($5,500 bases of property held immediately after the cancellation plus $600 savings minus $6,000 student loan).

Mya must reduce her bases in each item of property in proportion to her total adjusted bases in all her property. Thus, she reduces her basis in the furniture by $91 ($100 x 5,000/5,500) and her basis in the jewelry by $9 ($100 x 500/5,500).

All other tax attributes.   If the canceled debt is excluded by reason of the bankruptcy or insolvency exclusions, you must use the excluded debt to reduce the following tax attributes (but not below zero) in the order listed unless you elect to reduce the basis of depreciable property first, as explained later. The reduction of tax attributes must be made after figuring your income tax liability for 2012.

  1. Net operating loss (NOL). First reduce any 2012 NOL and then reduce any NOL carryover to 2012 (after taking into account any amount used to reduce 2012 taxable income) in the order of the tax years from which the carryovers arose, starting with the earliest year. Reduce the NOL or carryover by one dollar for each dollar of excluded canceled debt.

  2. General business credit carryover. Reduce the credit carryover to or from 2012. Reduce the credit carryovers to 2012 in the order in which they are taken into account for 2012. For more information on the credit ordering rules for 2012, see the Instructions for Form 3800, General Business Credit. Reduce the carryover by 331/3 cents for each dollar of excluded canceled debt.

  3. Minimum tax credit. Reduce the minimum tax credit available at the beginning of 2013. Reduce the credit by 331/3 cents for each dollar of excluded canceled debt.

  4. Net capital loss and capital loss carryovers. First reduce any 2012 net capital loss and then any capital loss carryover to 2012. Reduce the net capital loss or carryover by one dollar for each dollar of excluded canceled debt.

  5. Basis. Reduce the bases of the property you hold at the beginning of 2013 in the following order (and, within each category, in proportion to adjusted basis).

    1. Real property (other than real property held for sale in the ordinary course of business) used in your trade or business or held for investment that secured the canceled debt.

    2. Personal property (except inventory and accounts and notes receivable) used in your trade or business or held for investment that secured the canceled debt.

    3. Other property (except inventory, accounts receivable, notes receivable, and real property held primarily for sale to customers) used in your trade or business or held for investment.

    4. Inventory, accounts receivable, notes receivable, and real property held primarily for sale to customers.

    5. Personal-use property (property not used in your trade or business nor held for investment).

    Reduce the basis by one dollar for each dollar of excluded canceled debt. However, the reduction cannot be more than the excess of the total bases of the property and the amount of money you held immediately after the debt cancellation over your total liabilities immediately after the cancellation.

    For allocation rules that apply to basis reductions for multiple canceled debts, see Regulations section 1.1017-1(b)(2). Also see Election to reduce the basis of depreciable property before reducing other tax attributes, later.

  6. Passive activity loss and credit carryovers. Reduce the passive activity loss and credit carryovers from 2012. Reduce the loss carryover by one dollar for each dollar of excluded canceled debt. Reduce the credit carryover by 331/3 cents for each dollar of excluded canceled debt.

  7. Foreign tax credit. Reduce the credit carryover to or from 2012. Reduce the credit carryovers to 2012 in the order in which they are taken into account for 2012. Reduce the carryover by 331/3 cents for each dollar of excluded canceled debt.

Election to reduce the basis of depreciable property before reducing other tax attributes.   You can elect to reduce the bases of depreciable property you held at the beginning of 2013 before reducing other tax attributes. You can reduce the basis of this property by all or part of the canceled debt. Basis of property is reduced in the following order.

  1. Depreciable real property used in your trade or business or held for investment that secured the canceled debt.

  2. Depreciable personal property used in your trade or business or held for investment that secured the canceled debt.

  3. Other depreciable property used in your trade or business or held for investment.

  4. Real property held primarily for sale to customers if you elect to treat it as if it were depreciable property on Form 982.

  Basis reduction is limited to the total adjusted bases of all your depreciable property. Depreciable property for this purpose means any property subject to depreciation or amortization, but only if a reduction of basis will reduce the depreciation or amortization otherwise allowable for the period immediately following the basis reduction. If the amount of canceled debt excluded from income is more than the total bases in depreciable property, you must use the excess to reduce the other tax attributes in the order described earlier under All other tax attributes. In figuring the limit on the basis reduction in (5), Basis, use the remaining adjusted bases of your properties after making this election. See Form 982 for information on how to make this election. The election can be revoked only with IRS consent.

Recapture of basis reductions.   If you reduce the basis of property under these provisions and later sell or otherwise dispose of the property at a gain, the part of the gain due to this basis reduction is taxable as ordinary income under the depreciation recapture provisions. Treat any property that is not section 1245 or section 1250 property as section 1245 property. For section 1250 property, determine the depreciation adjustments that would have resulted under the straight line method as if there were no basis reduction for debt cancellation. See Publication 544 or Publication 225 for more details on sections 1245 and 1250 property and the recapture of gain as ordinary income.

Qualified Farm Indebtedness

If you exclude canceled debt from income under both the insolvency exclusion and the exclusion for qualified farm indebtedness, you must first reduce your tax attributes by the amount excluded under the insolvency exclusion. Then reduce your remaining tax attributes (but not below zero) by the amount of canceled debt that qualifies for the farm debt exclusion.

In most cases, when reducing your tax attributes for canceled qualified farm indebtedness excluded from income, reduce them in the same order explained under Bankruptcy and Insolvency, earlier. However, do not follow the rules in item (5), Basis. Instead, reduce only the basis of qualified property. Qualified property is any property you use or hold for use in your trade or business or for the production of income. Reduce the basis of qualified property in the following order.

  1. Depreciable qualified property. You can elect on Form 982 to treat real property held primarily for sale to customers as if it were depreciable property.

  2. Land that is qualified property and is used or held for use in your farming business.

  3. Other qualified property.

Qualified Real Property Business Indebtedness

If you make an election to exclude canceled qualified real property business debt from income, you must reduce the basis of your depreciable real property (but not below zero) by the amount of canceled qualified real property business debt excluded from income. The basis reduction is made at the beginning of 2013. However, if you dispose of your depreciable real property before the beginning of 2013, you must reduce its basis (but not below zero) immediately before the disposition. Enter the amount of the basis reduction on line 4 of Form 982.

Example 1.

In 2007 Curt bought a retail store for use in a business he operated as a sole proprietorship. Curt made a $20,000 down payment and financed the remaining $200,000 of the purchase price with a bank loan. The bank loan was a recourse loan and was secured by the property. He used the property in his business continuously since he bought it and had no other debt secured by that depreciable real property. In addition to the retail store, Curt owned depreciable equipment and furniture with an adjusted basis of $50,000. His tax attributes included the basis of depreciable property, a net operating loss, and a capital loss carryover to 2012.

Curt's business encountered financial difficulties in 2012. On September 26, 2012, the bank financing the retail store loan entered into a workout agreement with him under which it canceled $20,000 of the principal amount of the debt. Immediately before the bank entered into the workout agreement, he was insolvent to the extent of $12,000. At that time, the outstanding principal balance on the retail store loan was $185,000, the FMV of the store was $165,000, and the adjusted basis was $210,000 ($220,000 cost minus $10,000 accumulated depreciation). The bank sent him a 2012 Form 1099-C showing discharged debt of $20,000 in box 2.

Curt must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business indebtedness. Under the insolvency exclusion rules, he can exclude $12,000 of the canceled debt from income. Curt elects to reduce his basis of depreciable property before reducing other tax attributes. Under that election, he must first reduce his basis in the depreciable real property used in his trade or business that secured the canceled debt. After the basis reduction, His adjusted basis in that property is $198,000 ($210,000 adjusted basis before entering into the workout agreement minus $12,000 of canceled debt excluded from income under the insolvency exclusion).

The exclusion for qualified real property business indebtedness is limited to $20,000, the excess of the outstanding principal amount of the qualified real property business indebtedness (immediately before the cancellation) over the FMV (immediately before the cancellation) of the real property securing the debt ($185,000 minus $165,000). Curt's exclusion is also limited to $198,000, the total adjusted basis (determined after reduction for the canceled debt excluded under the insolvency exclusion) of his depreciable real property he held immediately before the cancellation. Since both of these limits exceed the $8,000 of remaining canceled debt ($20,000 minus $12,000), he can exclude $8,000 under the qualified real property business indebtedness exclusion.

Curt checks the boxes on lines 1b and 1d of Form 982. He completes Part II of Form 982 to reduce his basis in the depreciable real property by $20,000, the amount of the canceled debt excluded from income. He enters $8,000 on line 4 and $12,000 on line 5.

Example 2.

Bob owns depreciable real property used in his retail business. His adjusted basis in the property is $145,000. The FMV of the property is $120,000. The property is subject to $134,000 of recourse debt which is secured by the property. Bob had no other debt secured by that depreciable real property. Bob also had a $15,000 NOL in 2012.

During 2012, Bob entered into a workout agreement with the lender under which the lender canceled $14,000 of the debt on the real property used in his business. Immediately before the cancellation, Bob was insolvent to the extent of $10,000. He excludes $10,000 of the canceled debt from income under the insolvency exclusion. As a result of that exclusion, he reduced his NOL by $10,000.

Bob may be able to exclude the remaining $4,000 of canceled debt from income under the qualified real property business indebtedness provision, if he elects to apply it. The amount he can exclude is subject to both of the following limits.

  • The excess, if any, of the outstanding principal amount of the qualified real property business debt (immediately before the cancellation) over the FMV (immediately before the cancellation) of the business real property securing the debt (the excess of $134,000 over $120,000, which equals $14,000).

  • The total adjusted bases of depreciable property held immediately before the cancellation of debt ($145,000).

Since both limits ($14,000 and $145,000) are more than the remaining $4,000 of canceled debt, Bob can also exclude that $4,000 of canceled debt.

Bob checks the boxes on lines 1b and 1d of Form 982 and enters $14,000 on line 2. Bob completes Part II of Form 982 to reduce his basis of depreciable real property and his 2012 NOL by entering $4,000 on line 4 and $10,000 on line 6. None of the canceled debt is included in his income.

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