By Eric Rothenberg –

When your mortgage company lowers the principal amount you owe, or they forgive some or all of the principal amount you owe, you will receive Form 1099-COD for cancellation of debt or indebtedness and they will report it to the IRS. The instructions on the form  tells you that you must report such amount as income on your tax return. But they don’t tell you that it may not be income to you at all! And you can save a lot in income taxes if you have a tax return preparer that knows the rules. This is not something you should do yourself as the rules are complex and require special reporting. Interest on the debt forgiven may or may not be considered as well.

• We start with the notion that Forgiven Debt is income under IRC Section 61(a)(12). There are several exceptions to that rule. Under Section 108(a)(1)(A), the income is excluded if it was forgiven in a Title 11, (bankruptcy) case.

• Even if you did not file for bankruptcy, the income is excluded if you were “insolvent” at the time the debt was forgiven. This is in IRC Section (a)(1)(B). This means calculation the fair market value of all your assets and liabilities at the time the debt was cancelled. If liabilities are greater, then the income is excluded. Technically you have to do it just before the debt was cancelled and just after because if the cancellation made you solvent, then some or all may still be included in your income.

• There is also a special exception to not including the forgiven debt in income if it was debt secured by your principal residence. Thus, if it was forgiven and you were neither in bankruptcy nor insolvent, it’s still not income. There are complex rules for this as well (IRC Section 108(a)(1)(E).

• There is yet another exception to having to report it as income if the indebtedness related to Qualified real property business indebtedness [IRC Section 108(a)(1)(D)]. This section too is very complex but relates to property held in a trade or business (i.e. depreciable property used in your business or rental property)

• There is a worksheet to complete to figure this out and also you MUST reduce certain of your tax attributes (basis, credits, carryover, etc) and report those reductions on a special form too.

• This is a very complex area that many accountants and tax preparers know too little about and it’s often an audit issue. Both Massachusetts and the IRS look very carefully at these because the income was reported to the IRS and when they don’t see it on your income tax return, they will look very carefully at this.