If debt is cancelled or discharged, the amount forgiven is usually taxable income. There are exceptions if the cancelation occurs in bankruptcy or for certain qualifying home mortgages.
If the debtor was insolvent at the time of the cancellation (the person’s liabilities exceeded the sum of their assets), then an election can be made to reduce the basis in depreciable property owned by the debtor instead of recognizing the cancelled debt as income.
The effect of this election is to postpone taxation of the cancelled debt. By reducing the basis in depreciable property, the reduction will reduce future depreciation deductions and produce a larger gain on sale of the asset. The election should be considered when postponing the income would be beneficial.
For example, assume a taxpayer owes $100,000 on a rental property which has been foreclosed and the debt is forgiven. Normally the $100,000 debt forgiven is taxable income to him. Further assume the taxpayer is insolvent and owns a second rental property with a basis of $250,000. The taxpayer can elect to reduce the basis of the second property to $150,000 instead of paying tax on the $100,000 of debt forgiven.
