Debt Cancellation

Sometimes debtors may be able to negotiate their way out of their debts or decrease their debts by talking it over with their creditors.  Elisabeth Leamy, an ABC News Consumer Correspondent discussed in January 2009 that if someone is close to bankruptcy, the individual might think about contacting lenders and credit card companies to ask if the individual can pay off less than the full debt. According to Leamy, some creditors have forgiven up to 70% of an individual’s debt in fear that the economy may not turn around and may just get worst.  Creditors may be willing to just take what a debtor can pay.

Whenever debt gets cancelled, the individual should evaluate whether there is a loss to use to offset the reduction.  It would not be desirable for the debtor to end up with a gain or income to report when tax season comes around.

Generally, when there is debt cancellation, the debtor recognizes cancellation of debt income, except in these situations:

1.         The discharge happens in a Title 11 bankruptcy. The individual is under the bankruptcy court’s jurisdiction and the court grants the discharge or debtor is under a court approved plan.

2.         The discharge happens when the individual is insolvent, with determination for insolvency based on the liabilities amount and assets value immediately prior to the discharge.

3.         The debt discharged is qualified farm indebtedness.  This is debt incurred directly in the a farm operation.

4.         If other than a C corporation, the indebtedness discharged is qualified real property indebtedness.  This is debt incurred or assumed after 1992 to acquire, construct, or substantially improve real property used in a business or trade that is discharged after 2006 and prior to 2013. The exclusion is available for debt secured by a principal residence and if the discharge involves a decline in the residence value or to the taxpayer’s financial condition.

Debt cancellation reduces income tax in:

1.         General business credits;

2.         Minimum tax credits;

3.         Net operating loss carryovers;

4.         Capital loss carryovers;

5.         Depreciable property basis;

6.         Passive activity loss and credit carryovers; and

7.         Foreign tax credit carryovers.

Contact an experienced New York bankruptcy attorney for counseling on bankruptcy proceedings to make the process less intimidating.