What a Forgiven Balance Is at Tax Time

Answer first: only certain entities report, and reporting is not the same as taxability

The reporting statute applies to an applicable entity. It defines that term in two branches: an executive, judicial or legislative agency as defined in a cross-referenced provision of the title governing money and finance, and an applicable financial entity.

Applicable financial entity is then defined as a financial institution described in either of two named sections and any credit union; several named federal agencies and corporations and any other federal executive agency, and any successor or subunit of them; certain supervised and examined subsidiaries of such institutions; and any organization a significant trade or business of which is the lending of money.

That last branch is the widest, and it is the one that determines whether a non-bank creditor is inside the system. It asks whether a significant trade or business of the organization is the lending of money. It does not ask whether the organization is owed money.

The reporting duty is triggered where such an entity discharges an indebtedness of any person of at least six hundred dollars during a calendar year, and the statute states that the subsection does not apply to any discharge of less than six hundred dollars. The regulation states the same amount and adds that multiple discharges of less than that amount are not required to be aggregated unless the separate discharges are pursuant to a plan to evade the reporting requirements.

The regulation then makes the central point explicitly. Except as otherwise provided, discharged indebtedness must be reported regardless of whether the debtor is subject to tax on the discharged debt under the income and discharge sections or otherwise by applicable law. Whether a form is filed and whether an amount is taxable are separate questions decided by separate rules.

What counts as a discharge for reporting purposes

The regulation makes reporting turn on an identifiable event rather than on the economics. It states that, solely for the reporting section's purposes, a discharge of indebtedness is deemed to have occurred if and only if an identifiable event has occurred, whether or not an actual discharge has occurred on or before that date.

Seven identifiable events are listed. A discharge in bankruptcy. A cancellation or extinguishment that renders a debt unenforceable in a receivership, foreclosure or similar proceeding in a federal or state court. A cancellation or extinguishment on the expiration of the statute of limitations for collection, subject to a stated limitation, or on the expiration of a statutory period for filing a claim or commencing a deficiency judgment proceeding. A cancellation or extinguishment under an election of foreclosure remedies that statutorily extinguishes or bars the creditor's right to pursue collection. A cancellation or extinguishment that renders a debt unenforceable in a probate or similar proceeding. A discharge under an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration. And a discharge pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt.

Two of those come with definitions that matter.

For the statute of limitations event, the regulation states that an identifiable event occurs only if, and at such time as, a debtor's affirmative statute of limitations defense is upheld in a final judgment or decision of a judicial proceeding, and the period for appealing has expired. The mere running of a limitations period is not the event.

For the discontinued-collection event, the regulation defines a creditor's defined policy to include both a written policy and the creditor's established business practice — giving as an example an established practice of discontinuing collection activity and abandoning debts after a particular non-payment period.

Where a discharge occurs before an identifiable event, the regulation permits the creditor, at its discretion, to report it.

What the return and the payee statement contain

The regulation requires the return to include the name, address and taxpayer identification number of each person for which there was an identifiable event during the calendar year; the date the identifiable event occurred; the amount of indebtedness discharged; an indication whether the identifiable event was a discharge in bankruptcy, if known; and any other information required by the form or its instructions.

The statute requires the parallel payee statement. Every applicable entity required to make a return must furnish to each person whose name is required to be on it a written statement showing the name and address of the entity required to make the return, and the information required to be shown on the return with respect to that person. It must be furnished on or before the thirty-first of January of the year following the calendar year for which the return was made.

Filing deadlines for the return itself are stated in the regulation as the twenty-eighth of February, or the thirty-first of March if filed electronically, of the year following the calendar year in which the identifiable event occurs — with a special rule for indebtedness discharged in bankruptcy, reported for the later of the year in which the amount first becomes ascertainable or the year of the identifiable event.

The statute also provides an alternative for government agencies. In lieu of making a return, an agency described in the governmental branch of the definition may submit information sufficient for the Secretary to complete the return on the agency's behalf, after which the Secretary completes it and provides a copy to the agency.

The reporting exceptions, including one that removes most bankruptcies

The regulation carves several categories out of reporting, and the first is substantial.

For a discharge of indebtedness in bankruptcy, reporting is required only if the creditor knows, from information included in the reporting entity's books and records pertaining to the indebtedness, that the debt was incurred for business or investment purposes. The regulation defines those terms: business purposes means incurred in connection with the conduct of any trade or business other than the trade or business of performing services as an employee; investment purposes means incurred to purchase property held for investment as defined in a cross-referenced section.

The discharge of an amount of indebtedness that is interest is not required to be reported.

In a lending transaction, the discharge of an amount other than stated principal is not required to be reported. The regulation defines a lending transaction as any transaction in which a lender loans money to, or makes advances on behalf of, a borrower, including revolving credits and lines of credit.

There is also a category for indebtedness of foreign debtors held by foreign branches of United States financial institutions, with a definition that turns on the branch conducting an active banking or similar business outside the United States as a regularly maintained permanent place of business with at least one employee regularly in attendance during normal working hours.

The pattern across these exceptions is that they narrow reporting to principal, to non-bankruptcy discharges, and to consumer-versus-business distinctions the creditor's own records can answer. None of them changes whether an amount is in income.

The income side, and the exclusion that turns on deductibility

The taxability question is governed by a different section, which states its rule as a set of exclusions from gross income.

Gross income does not include an amount that would otherwise be includible by reason of the discharge of indebtedness if the discharge occurs in a bankruptcy case; if the discharge occurs when the taxpayer is insolvent; if the discharged indebtedness is qualified farm indebtedness; if, for a taxpayer other than a certain kind of corporation, it is qualified real property business indebtedness; or if it is qualified principal residence indebtedness discharged before a stated date or under a written arrangement entered into before that date.

The section defines insolvent as the excess of liabilities over the fair market value of assets, and directs that whether and by how much a taxpayer is insolvent be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge. The insolvency exclusion is limited: the amount excluded may not exceed the amount by which the taxpayer is insolvent.

The section also orders the exclusions against each other. The bankruptcy exclusion takes precedence over the others. The insolvency exclusion takes precedence over the farm and real property business exclusions. And the principal residence exclusion takes precedence over insolvency unless the taxpayer elects otherwise.

One further rule in the same section deserves separate attention because it is easy to miss and is not tied to insolvency at all. No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.

That sentence links this section to the medical expense rules. Whether payment of a particular liability would have given rise to a deduction depends on the taxpayer's own facts, on the definition of medical care, on the percentage-of-income floor, and on whether the taxpayer itemizes at all. Nothing here decides that for anyone; the provision simply exists, and it is the reason a forgiven balance and a taxable amount are not automatically the same figure.

The two systems can therefore disagree in both directions. A form can be filed for an amount that is not in income, because the regulation requires reporting regardless of taxability. And an amount can be in income with no form filed, because the entity that forgave it was not an applicable entity.