Cancellation of Debt Income

Sometimes debtors may be able to negotiate with their creditors to decrease their debts. Elisabeth Leamy, an ABC News Consumer Correspondent wrote in January 2009 that if someone is in the brink of bankruptcy, s/he might want to approach any credit card companies and ask to pay off less than the full amount. According to Leamy, some banks have forgiven up to 70% of a consumer’s debt. Banks fear that the economic climate is only going to get worse so they’re taking what they can.

Banks may also not want to deal with a collections lawsuit. Collections cases tend to drag out because of the many cases in the court system. In litigation, there are court costs and attorneys’ fees, which the plaintiffs may not get back.

Whenever debt is cancelled, the NY debtor should look over whether there is a loss deduction to use to offset it so that the New York debtor does not come out with a gain or income to report for taxes.

As a general rule, when a debt is cancelled, the debtor recognizes cancellation of debt income, except in the following situations:

1. The discharge occurs in a Title 11 bankruptcy case. The debtor is under the jurisdiction of the bankruptcy court and the discharge is granted by the court or under a court approved plan approved.
2. The discharge occurs when the debtor is insolvent, with insolvency determination based on the amount of liabilities and the value of the assets immediately before the discharge.
3. The debt discharged is qualified farm indebtedness, meaning debt incurred directly in the operation of a farm.
4. If other than a C corporation, the indebtedness discharged is qualified real property indebtedness, meaning debt incurred or assumed after 1992 to acquire, construct, or substantially improve real property used in a trade or business that is discharged after 2006 and before 2013. The exclusion is available for debt secured by a principal residence and if the discharge relates to a decline in the value of the residence or to the financial condition of the taxpayer.

Cancellation of debt income reduces tax attributes in:

1. Net operating loss carryovers which allow a debtor to reduce current profits with prior losses;
2. General business credits;
3. Minimum tax credits;
4. Capital loss carryovers;
5. Basis of depreciable property;
6. Passive activity loss and credit carryovers; and
7. Foreign tax credit carryovers.

Consult an experienced New York bankruptcy attorney on debt cancellation.