John Bullis: Sometimes cancellation of debt is not income

As with most tax rules, cancellation of debt is taxable income, unless an exception applies.

If the debt is cancelled in bankruptcy or during insolvency or is a qualified farm debt or a qualified real property business debt then there is no income to be taxed.

A new exception to being taxable is the student loan discharged if the discharge was due to the death or total and permanent disability of the student.

Loans made by the United States; a state (or a political subdivision); certain tax-exempt public benefit corporations that control a municipal hospital whose employees are deemed to be public employees under state law; an educational organization that originally received the funds and that loan was from United States, a state, or a tax-exempt public benefit corporation; or private education loans-those are eligible for the exclusion (not taxable income).

Some education loans have resulted in exclusion from the debt cancellation rules where the school was closed and the student took out federal student loans to finance the attendance at that school.

In listing the assets and liabilities at the date the loan was cancelled, the tax court case of Vincent and Stephanie Hamilton is important. Their adult son needed money to go to school so Mr. Hamilton borrowed student loans. In 2008 he injured his back and was permanently disabled. In 2011 $159,000 of student loans was cancelled, discharged. The Hamiltons filed form 982, claiming their liabilities were much more than their assets, $165,871 more liabilities.

However, the parents received a nontaxable cash distribution relating to his 14% interest in a limited liability company. Then the parents transferred $323,000 to son Andrew’s bank savings account. In 2011 Mrs. Hamilton regularly transferred money from Andrew’s savings account to the parents joint account to pay most of the household bills.

The tax court said the parents exercised “dominion and control” over the savings account in the son’s name. The court then found the listing of assets was increased. The cancellation of debt was taxable after all.

It is good to look at all the exceptions to having taxable income when debt is cancelled.

Did you hear “We sometimes underestimate the influence of little things.” Charles W. Chesnutt