Income from the Cancellation of Indebtedness

Recent tough economic times have led some lenders and borrowers to work out debt modifications, including the cancellation or forgiveness of some or all of the debt.  The amount of the cancelled debt generally must be reported as income on your tax return.  If a financial institution forgives the debt, it is required to issue Form 1099-C, reporting the amount of the forgiveness to the IRS.  There are many specific provisions that excuse the debtor from having to pay tax on the forgiven debt.  These include the following:

• Discharge of a private debt from a relative or friend that is intended as a gift,
• Discharge of student loans of doctors, nurses and teachers who agree to serve in rural or low income areas and meet certain conditions,
• Discharge of debt that, if paid, would have resulted in a tax deduction (e.g. accrued mortgage interest expense),
• Reduction in price for the purchase of property,
• Discharge of debt through bankruptcy,
• Discharge of debt of an insolvent taxpayer,
• Discharge of qualified farm debt,
• Discharge of qualified real property business debt, and
• Discharge of qualified principal residence debt.

There are many complicated rules and time limits associated with these exceptions.  Most of these exceptions must be reported to the IRS on Form 982 and result in the reduction of certain tax attributes, such as the tax basis of property or the carryover of tax losses.

Is a Roth IRA Conversion a Good Idea?

This article assumes that you are familiar with the features of a Roth IRA and the opportunity to convert your traditional IRA to a Roth IRA. Refer to my November 11, 2009 post for some background information. This post reviews a few “rules of thumb” to determine whether you might be a good candidate for a conversion. There is no mathematical benefit to a conversion if your income tax rate in retirement is the same as the tax rate for the year of conversion and you pay the conversion tax with IRA funds. Some other factor is needed for the conversion to be favorable, such as:

• You have non-IRA funds that can be used to pay the conversion tax.
• Your average tax rate will be higher in the future (when you retire and draw upon IRA funds) than your marginal tax rate at conversion.
• You have a net operating loss carryover (but not a capital loss carryover) or an unused charitable contribution that could offset some of the conversion income.

In addition, if you have one of the following characteristics, you may find the Roth conversion useful:

• You don’t need the IRA to fund retirement expenses and can leave it to your heirs.
• Your proportion of nondeductible IRA tax basis to the total value of all your IRAs is over 50%.
• Your IRA assets are temporarily depressed in value or are expected to greatly increase in value in the future.

However, a Roth IRA conversion is not a good idea for most middle- and upper-middle-income people. Such people need to rely on their IRA to fund retirement. The marginal tax paid when converting the traditional IRA will almost always be higher than the average tax paid in retirement when taking IRA distributions. Even if tax rates increase in the future, those increases will mostly affect the upper tax brackets applicable to very high income earners. Not many taxpayers in the 28% marginal bracket today will be pay an average 28% rate in retirement because the income tax brackets are indexed for inflation, and the average of lower brackets will always be less than the highest rate bracket to which you are subject. Therefore, be very careful of making a Roth IRA conversions if:

• You are not consistently in the top income tax bracket, and if not,
• You will pay conversion tax at a marginal tax rate above 15%.