If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain ‘‘tax attributes.’’ Tax attributes include the basis of certain assets and the losses and credits listed next. By reducing these tax attributes, tax on the canceled debt is in part postponed instead of being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation.
If a separate bankruptcy estate was created, the trustee or debtor-in-possession must reduce the estate’s attributes (but not below zero) by the canceled debt. See Individuals under chapter 7 or chapter 11, later.
Order of reduction. Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below. However, you may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. This choice is discussed later.
Net operating loss. First, reduce any net operating loss for the tax year in which the debt cancellation takes place, and any net operating loss carryover to that tax year.
General business credit carryovers. Second, reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit.
Minimum tax credit. Third, reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation.
Capital losses. Fourth, reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.
Basis. Fifth, reduce the basis of your property as described under Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property.
Passive activity loss and credit carryovers. Sixth, reduce any passive activity loss or credit carryover from the tax year of the debt cancellation.
Foreign tax credit. Last, reduce any carryover, to or from the tax year of the debt cancellation, of an amount used to determine the foreign tax credit or the Puerto Rico and possession tax credit.
Amount of reduction. Except for the credit carryovers, reduce the tax attributes listed earlier one dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 331/3 cents for each dollar of canceled debt that is excluded from income.
Making the reduction. Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing net operating losses and capital losses, first reduce the loss for the tax year of the debt cancellation, and then any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. Make the reductions of credit carryovers in the order in which the carryovers are taken into account for the tax year of the debt cancellation.
Individuals under chapter 7 or chapter 11. In an individual bankruptcy under chapter 7 (liquidation) or chapter 11 (reorganization) of title 11, the required reduction of tax attributes must be made to the attributes of the bankruptcy estate, a separate taxable entity resulting from the filing of the case. Also, the trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes. See the discussion of The Bankruptcy Estate, earlier.
If any amount of the debt cancellation is used to reduce the basis of assets as discussed under Reduction of Tax Attributes, the following rules apply to the extent indicated.
When to make the basis reduction. Make the reduction in basis at the beginning of the tax year following the tax year of the debt cancellation. The reduction applies to property held at that time. See section 1.1017–1 of the Income Tax Regulations for more information.
Bankruptcy and insolvency reduction limit. The reduction in basis because of canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later.
Exempt property under title 11. If debt is canceled in a bankruptcy case under title 11 of the United States Code, make no reduction in basis for property that the debtor treats as exempt property under section 522 of title 11.
Election to reduce basis first. You (the estate in the case of an individual bankruptcy under chapter 7 or 11) may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.
Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. You may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. You must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, you can only revoke it with IRS approval. However, if you establish reasonable cause, you may make the choice with an amended return or claim for refund or credit.
Making elections. Make the election to reduce the basis of depreciable property before reducing other tax attributes as well as the election to treat real property inventory as depreciable property, on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
Recapture of basis reductions. If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain that is from this basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of this basis reduction as a depreciation deduction and by treating any such basis-reduced property that is not already either section 1245 or section 1250 property as section 1245 property. In the case of section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation. Sections 1245 and 1250 and the recapture of gain as ordinary income are explained in chapter 4, Dispositions of Depreciable Property, in Publication 544, Sales and Other Dispositions of Assets.