When a creditor cancels or forgives a debt you owe on investment property, it’s one of the few situations where the IRS can require you to recognize gross income -- even though you don’t receive a cash payment. However, the tax law does provide for two exceptions that allow you to exclude the debt cancellation on investment property from your gross income.
Taxable Debt Cancellations
When you finance the purchase of investment property with a loan or credit, you have a legal obligation to repay the debt. This covers all types of financing, whether it’s purchasing stocks on margin, or obtaining a bank loan to purchase commercial real estate. And whenever your creditor cancels or forgives the debt you owe, you must include the amount as gross income on your tax return. However, this doesn’t include situations where you negotiate the modification of existing repayment terms with a creditor. For example, if you agree to accelerate the repayment of a bank loan in exchange for a reduction in loan principal, this situation doesn’t constitute a debt cancellation.
Receiving Form 1099-C
The IRS requires creditors to report all debt cancellations of $600 or more on form 1099-C and to provide you with a copy. Receiving a 1099-C in the mail notifies you that the creditor’s debt cancellation constitutes taxable income. You must include this as other income on your federal income tax return. However, if one of your creditor’s cancels a debt for which the amount doesn’t require the filing of a 1099-C, this doesn’t mean you can ignore its tax implications. The IRS still requires you to include the cancellation in your gross income.
If you borrow money from a friend or family member to purchase investment property, and he decides to cancel your obligation to repay the loan, it’s not necessary to include the outstanding loan in your gross income. Under the federal gift tax law, the recipient of a gift doesn’t include the value of the gift in gross income. However, the friend or family member who gave you the money may end up incurring a gift-tax liability as a result of the debt cancellation.
In the event you become insolvent and file chapter 11 bankruptcy to eliminate or reduce your outstanding debts, you can exclude any cancellation of debts that relate to your investment properties from your gross income. To take advantage of the exclusion, the debt cancellation must be enforceable by the bankruptcy court. However, the court may require you to liquidate some of your assets, including the investment property, to pay off a portion of your outstanding debts.
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