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May 08, 2010

Cancellation of Indebtedness Income

We hear a lot today about debtors being subject to cancellation of indebtedness income, sometimes referred to as discharge of indebtedness, which I will refer to as COD income.  What you also hear about is debtors complaining that it is unfair.  But, in fact, it is not unfair.  Rather, it is necessary, and what the debtors and their advisors should be looking at is whether there are any exclusions available to the debtor to avoid the income legitimately, and stop worrying about what is fair or unfair.

So, why is it necessary and fair to subject debtors to COD income.  Well, when a borrower receives money in a loan transaction, such as purchasing a home, the borrower does not have to include that money in income.  As a fundamental principle of tax, borrowed monies are excluded from gross income because the obligation to repay borrowed monies offsets the economic increment even though borrowed funds increase a taxpayer's assets.  But, when the obligation is later discharged without requiring the borrower to pay it back, the borrower has realized an accession to wealth.  Again, the receipt of the proceeds of a loan is not income because the receipt is offset by an obligation to repay the borrowed monies.  If the obligation to repay is then eliminated, the borrower realizes an accession to wealth that should be included in gross income (i.e., the COD income).   Under basic tax theory, that is absolutely fair and not requiring them to include it in income is where it would be unfair as a matter of principle.

What debtors and their advisors should be focusing on is what theories under common law and statute, allow the the debtors to avoid the income.  As an example, a debtor that is insolvent immediately before the discharge will likely be able to exclude a portion of the amount discharged from income, both under common law and statute. Debtors and their advisors should seek out competent tax advisors to assist with this analysis.

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« REMINDER REGARDING IRS’ RECORD RETENTION GUIDELINES | Main | APPLICATION OF ACCURACY RELATED PENALTIES »

May 08, 2010

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