Exceptions and Exclusions to CODI
There are five exceptions to CODI. An exception means that the debt is not included on the tax return on its own merits and does not need to meet any other exclusions or calculations. The exceptions are as follows:
1. Non-Recourse debt. As indicated in the earlier text and non-recourse debt is not the responsibility of the debtor over the amount of the collateral seized, unless the debtor does a “workout” with a different lender than the original creditor, than the CODI is included. But it may meet one of the exclusions later in the text.
2. Gifts. If the debt cancellation was intended as a gift from the creditor to the debtor there is no CODI. Clients should be aware that the creditor may have gift tax reporting requirements in this case.
3. Certain Student Loans. If there is a provision in the student loan that all or part of the debt will be forgiven if the student works for a specific period of time in a specific profession and location, the student who completely fulfills the agreement has no CODI for the portion of debt canceled. A common example is a medical doctor agreeing to go practice for a specified period of time in a remote location after graduation.
4. Purchase Price Reduction. If a debtor who is solvent buys a property from the seller and the seller (notice, seller, not banker) later reduces the selling price of the property there is no CODI, instead the debtor reduces their basis in the property by the amount of the reduction. This is similar to a Home Loan Modification discussed above but does not involve third party financing.
5. Deductible Debt. As discussed in the Schedule E example under unsecured debt earlier, if the amount of the CODI would have been deductible to the debtor if it had been paid then there is no CODI up to the amount of the deduction that would have been taken.
There are also five exclusions to CODI. The trick with the exclusions is they must be applied in the order presented and you may not skip to the one that works out best for the client. CODI from the same incident can qualify for more than one exception and/or exclusion. The exclusions are as follows:
1. Bankruptcy. If the debt is included in a bankruptcy estate under USC Title 11(Chapters 7 and 11 not 13), and the bankruptcy is completed without being dismissed, then there is no CODI and the debt is fully excluded.
2. Insolvency. If the debtor is insolvent (has more debts than assets) the debt is excluded up to the amount of the insolvency. We will discuss this in further detail shortly.
3. Qualified Farm indebtedness. A solvent farmer may elect to exclude qualified farm debt (debt incurred directly in the operation of the farm) up to the extent of their tax attributes.
4. Qualified real property business debt. A solvent debtor may elect to exclude CODI in connection with real property, directly secured by that real property or used in a trade or business up to the extent of their tax attributes.
5. Qualified Principal Residence Indebtedness (QPRI). As of the time of this writing this provision was due to expire on 12/31/2013. If the debtor has a home mortgage against their principal residence forgiven they may exclude a portion of it if that debt was secured by an acquisition loan to buy, build or substantially improve the home.