Accounting and Debt Forgiveness

When a debtor can no longer pay a loan or other type of liability, they have several options, including debt restructuring and processes that will lead to debt forgiveness. These options often change the debt into another form or remove it entirely, which can pose accounting problems, raising questions on what account the debt should be moved to. Accounting practices have adopted several basic rules to deal with these situations.

Debt Forgiveness

Debt forgiveness is also known as canceled debt. This typically occurs when a lender agrees to forgive a portion of the debt that borrowers owe. For instance, a borrower who can no longer make payments on a mortgage may be able to sell their house in a short sale. The money from the sold house goes to the lender to pay off the loan, and any remaining debt (or at least a percentage of it) is forgiven by the lender. A more drastic form of debt forgiveness occurs in different forms of bankruptcy.

Taxes

The IRS considers this forgiven debt to be a unique case. Essentially, the debtor once had an obligation to pay money, but has now had that obligation removed. To the IRS, this is functionally the same as the debtor receiving income, so the forgiven debt actually counts as earned income, money that the taxpayer would not otherwise have. As a form of income, the debtor must pay taxes on it according to current income tax regulations.

Tax Relief

Due to the housing market crash and other economic conditions, the federal government has instituted regulations that provide some measure of tax relief for debt forgiveness. Specifically, debtors can exclude the "income" they make when debt is discharged on their primary residence, due to a short sale, bankruptcy or other type of forgiveness (this regulation extends to 2012). Debt reduced through a restructuring of the mortgage can also be excluded from taxes.

Business Equity

In a business situation, forgiven debt can be a more complicated issue. Businesses that cannot pay bondholders may switch the funds they owe these investors into stocks, a type of debt forgiveness that switches the medium of payment. From an accounting perspective, although this changes the loan account (a full debit that closes the account) and equity (a credit that adds the same value in stock), the financial statement itself is not affected by the change.