The best-laid business plans can go awry. When that happens, everyone may be better off renegotiating the debt. If you do that, remember that the tax man has a seat at the table.
The default rule under the tax law is that debt forgiveness generates taxable income. Fortunately for distressed debtors, there are some important exceptions. The most important:
-A reduction in purchase-money debt for an asset can be treated as a reduction in your purchase price, rather than debt forgiveness income.
-Debts forgiven under the terms of a bankruptcy decree are tax-exempt.
- Debt forgiveness income is taxable to the extent a taxpayer is insolvent.
A taxpayer is "insolvent" to the extent the value of assets are less than the taxpayer's liabilities. If a taxpayer has a negative net worth of $100,000 and has debt of $110,000 forgiven, the $10,000 difference is taxable income.
There are also debt forgiveness exclusions when home mortgage debt is forgiven, for business real property acquisition debt forgiveness, and for farm indebtedness.
If a taxpayer has debt forgiven that is tax-exempt,, it's not usually a free lunch. If the taxpayer has unused loss carryforwards or tax credits, they may be reduced or eliminated by the debt cancellation income. Alternatively, you may find yourself with a lower basis in some of your property, increasing your gain or reducing your loss on an eventual sale.
Sometimes what seems like debt forgiveness isn't taxed that way. For example, if your debt is settled by foreclosure, you have a taxable sale of the secured property to the extent of its value. Only the debt forgiven in excess of the value of the surrendered collateral is debt forgiveness income that may eligible for an exclusion.
If property is foreclosed in settlement of non-recourse debt -- debt for which the creditor has no right to pursue the debtor beyond what is recovered in foreclosure -- the entire amount of the debt is considered to be the sale price of the property sold. This can be an expensive problem if the taxpayer has depreciated the property and has a low basis, triggering a big taxable gain on the foreclosure.
Taxation of debt forgiveness can be fiendishly complex. If you are negotiating a workoout, keep your tax advisor involved; after all, the IRS already is.
Image via Wikipedia