Op-Ed: Debt forgiveness and tax considerations
In upcoming years, the term “debt forgiveness” will become a common phrase among individuals, proprietorships, and businesses in Puerto Rico, but not for a good reason.
The Puerto Rico economy has been almost continuously in a recession for more than a decade. Furthermore, the devastation that Hurricane María brought to Puerto Rico has only made it worse for the stressed economy.
Consequently, both individuals as well as businesses have been forced to look for financing (i.e. loans), among other resources, to be able to overcome the financial crisis and keep their business operating.
In light of such a situation, deciding to look for debt to finance an operation with cash flow problems does not always go well. Herein, I will be addressing some of the most relevant tax consequences for a person (natural or juridical) who had a debt forgiven by a creditor.
Generally, forgiveness of debt will result in taxable income to the debtor. Such is the case when a taxpayer is solvent and a debt is cancelled (forgiven). In that event, the taxpayer shall generate taxable income for the amount of debt cancelled. For these purposes, the term “solvent” means the excess of assets over the liabilities of the taxpayer’s business.
Conversely, the Puerto Rico Internal Revenue Code provides certain situations in which the forgiveness of debt is not subject to taxation. Under the Code, such income is known as “income from discharge of indebtedness.”
According to the Code, the income from debt discharge, or part of said discharge, shall not be subject to the payment of income tax, if it results from the following:
- Debt discharge that occurs as a result of filing of a bankruptcy under Title 11 of the United States Code and the discharge is granted by the court
- Certain debt discharges related to student loans
- The debt discharge that occurs as part of a reorganization of a mortgage loan guaranteed by a qualified residence (provided that the original mortgage loan does not exceed $1 million)
- Debt discharge that occurs when the taxpayer is insolvent.
In the case of an insolvent taxpayer, the Code provides that such income be excluded, however, the exclusion of income shall not exceed the amount by which the taxpayer is insolvent. The debtor insolvency is determined based on the debtor’s assets and liabilities immediately before the discharge.
For a debtor to be considered insolvent, the liabilities should exceed the fair market value of the assets. There are cases in which the taxpayer will end up excluding part of the income, related to the cancelled debt, and the other part can be reported as income on the return.
Therefore, an adequate analysis and calculation must be made in order to avoid any tax assessment by the Puerto Rico Treasury Department in the future.
Treasury issued further guidance with respect to the taxation of income from debt discharge on Administrative Determination 16-14 (“AD 16-14”). Here, Treasury provided further requirements for (a) exclusion of income from debt discharge of a mortgage loan and (b) exclusion of income from debt discharge for debtor’s insolvency, among others.
In the case of a debt discharge because the debtor is insolvent, AD 16-14 requires the debtor to provide the creditor with a Report on Agreed Upon Procedures prepared by Certified Public Accountant with a valid license in Puerto Rico.
Such report will help the creditor determine whether the discharge will be reported as taxable or exempt to the debtor.
On the other hand, creditors who claim a deduction for loss regarding a debt discharge, shall provide an informative return to the debtor who benefitted from the discharge. The applicable informative return will depend on whether the income related to the discharges of debt is taxable or an exclusion from income.
The taxable amount or portion, shall be informed on Form 480.6A Informative Return – Income Not Subject to Withholding; and the amount or potion excluded from income shall be reported on Form 480.6 D, Informative Return – Exempt and Excluded Income and Exempt Income Subject to Alternate Basic Tax.
Therefore, it is important for any taxpayer who has or will be receiving a discharge of indebtedness, to contact their CPA to properly plan, calculate and report according to the provisions discussed above.