This Tax Tip Spotify Podcast and/or WordPress Blog Post understands that you have negotiated a reduction of a debt you incurred to purchase real estate and that you are seeking information on the tax consequences of the debt reduction.
Generally, if a creditor discharges you from a debt, you must include in your gross income the amount of the debt that has been discharged. The general theory behind this rule is that you realize an accession of wealth to the extent you have been released from a debt because the cancellation of the debt frees up assets that you would otherwise need to pay the debt. This type of income is generally referred to as either discharge of indebtedness (DOI) income or cancellation-of-debt (COD) income.
Under an exception to the general rule, if you negotiate with the seller-creditor for a reduction of the debt you incurred to purchase the property, the reduction in the debt is treated as a purchase price reduction rather than a discharge of debt. The theory behind this treatment is that the discharge reflects a decline in the value of the property. The resulting discharge of indebtedness is characterized not as taxable income but as a retroactive reduction of the purchase price. Note, however, that this exception does not apply to a reduction of such debt in a title 11 bankruptcy case or when the buyer is insolvent.
Although you are not required to recognize discharge-of-indebtedness income in such a case, you must reduce your basis in the property by the amount of the reduction in the debt.
The purchase price reduction exception does not apply where the only relationship between you and the creditor is that of debtor and creditor (i.e., where the creditor was not also the seller of the property). Thus, for example, in a generic credit card transaction, where a bank effectively lends you money to make various purchases, the only relationship between you and the bank is that of debtor and creditor, and the purchase-price-reduction exception does not apply. A limited exception may apply to the extent the debt reduction by the third-party lender is based on an infirmity that clearly relates back to the original sale – for example, the seller’s inducement of a higher purchase price by misrepresentation of a material fact or by fraud. Aside from this, however, no other debt reduction by a third-party lender will be treated as a purchase price adjustment.
Please call me at your convenience so that we can discuss the rules for a reduction of debt as they apply to your particular situation.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 05012021-1 320-295)