 Income tax 2021-2022, business income part number five. Get ready to get refunds to the max, dive into income tax 2021-2022. Most of this information can be found in publication 334, Tax Guide for Small Business Tax Year 2021. Looking at the income tax formula, line one income, we would have a sub-schedule, basically an income statement, and expenses, expenses basically being deductions. The net then rolling in to line one income on the income tax formula as well as on the first page of the form 1040 we see here. It would go from the schedule C to the schedule 1 to the first page of the form 1040 here, line number eight. We then have the schedule C, basically an income statement. We're still focusing in on the income part of the income statement as opposed to the expense part. We're now looking at the canceled debt. So the following explains the general rule for including canceled debt in income and the exceptions to the general rule. So now we've got debt that is going to be canceled. So that means we owe money to somebody else, possibly a bank, for example, and they say you no longer owe us the money. And you would think then the general rule would be that you basically got income from that because you can imagine a situation where you got a loan and then they said you don't got to repay the loan. You don't have to repay the loan. So that would mean then that you got kind of free money at that point. So you would think unless there's an exception, the government would want to call that income because you can basically imagine the situation. It's kind of like the bank. If you put the money into the exchange again, it would be kind of like the bank gave you the money, which would be income and then you gave the money back to pay off the loan. So that's one way you can kind of think about these transactions, try to implement the cash into it and see okay, yeah, it's basically an income transaction. Now we saw a PPP loan in the tax year, in the prior tax year, which is an example of this where they put stuff in because of the COVID situation for a loan, which if certain conditions were met, then they forgive the loan, which again, it's kind of like free money. So then of course you have the question, is there going to be an exception to a loan having the general rule where you would have to record the cancellation as income? So we have the general rule, generally if your debt is canceled or forgiven, other than as a gift or bequest to you, you must include the canceled amount in your gross income for tax purposes. Report the canceled amount on line 6 of Schedule C if you incur the debt in your business. If the debt is non-business debt, report the canceled amount on line 8C of Schedule 1. So clearly there would be a difference. The general rule, cancellation of debt, would be income in one way or another. If it was business debt, then generally you would think it would be on the Schedule C. If it was non-business debt that was canceled, then you're going to have to report it in income some other place Schedule 1. So exceptions, the following discussion covers some exceptions to the general rule for canceled debt. So obviously we would like to have an exception there because we don't want to include it in income. Price reduced after purchase. So you purchase something and then before you pay them, they reduce the price. If you owe a debt to the seller for property you bought and the seller reduces the amount you owe, you generally do not have income from the reduction. Unless you are bankrupt or insolvent, treat the amount of the reduction as a purchase price adjustment and reduce your basis in the property. So in other words, you purchase something and then before you pay them, they basically reduce the amount that you owe them instead of putting it on the books at the original higher amount and then possibly having that reduction income. Instead, we just reduce the amount of the thing that you purchased that we're going to be purchasing. So we're reducing the purchase price. Then we have the deductible debt. You do not realize income from a canceled debt to the extent the payment of the debt would have led to a deduction. So that could be a little confusing. Let's just imagine how this kind of works out. For example, you put it on the books as a liability. You get cash, you put it on the books as a liability. Now, the liability is not something on the schedule C because it's a balance sheet account and we're only recording the schedule C, the income side of the bookkeeping. And then when you pay off the debt, normally with normal payments, then you would be paying off a principal portion, lowering the liability, not deductible portion typically, and then an interest portion, the interest portion typically being deductible. You can imagine a situation where this accumulates interest and accumulates on principal because you haven't paid the debt and then they cancel the debt at that point in time, possibly because you can't pay it so that you come up to an agreement where they cancel the debt. Well, then in that case then, you do not realize the income from the canceled debt to the extent that the payment of the debt would have led to a deduction. So you would think that might be like the interest portion of the amount that is owed. You could kind of imagine that in more detail. Once again, you could try to impute cash into the transaction to kind of think about how this might work. What kind of happened if you had cash exchanged in hands? The bank canceled the debt. You can imagine them giving you money that you're just going to give back to them. They give you money cancelling the principal and interest portion of the debt, which would be income to you. So now we'd have income and then you take that income and you pay back off the debt that you owe, which part of that would just be paying off the principal, which you would think would not be deductible and part of it might pay off the interest that is owed, which may be deductible and so you would have that interest kind of component that would be the deductible component. So if you remove the cash from the transaction, then how much do you have to include in income? Well, we're just going to kind of net out the amount. If you would have got a deduction for it, we kind of net that out and therefore we're only going to include the amount that wouldn't be included in a deduction, which you would think would be kind of like the principal portion of the debt. So that's just a general recap of it. So example, you get accounting services for your business on credit. Later you have trouble paying your business debts, but you are not bankrupt or insolvent. Your accountant forgives part of the amount you owe for the accounting services, how you treat the canceled debt depends on the method of accounting. So on a cash method you do not include the canceled debt in income because payments of the debt would have been deductible as a business expense. So in this case we've got services, we haven't yet paid for the services, but we're on a cash basis method. So that means when they did the services we never put it on the books as basically as an expense. So we never got the deduction on the books because we hadn't paid the cash. And if we hadn't paid the cash and hadn't taken the deduction in that case if they cancel the debt we don't have to record it as income because we didn't get the deduction because we're on a cash basis. If it wasn't a cruel method you include the canceled debt in income because the expense was deducted when you incurred the debt. So let's say that the services happened in the prior year you're on an accrual method and you didn't yet pay for it but because you're on an accrual method you got the expense because you got the expense when the thing actually happened under the accrual method then they canceled the debt and the following year you would think then you'd have to record it as income because you got the benefit of the expense. Exclusions do not include canceled debt in income in the following situations. However, you may be required to file form 982 of tax attributes due to discharge of indebtedness. For more information you can see form 982. Number one, the cancellation takes place in a bankruptcy case under Title XI of the U.S. Code. So part of the benefits of the bankruptcy is to settle some of these issues. So if you're in bankruptcy that's going to kind of change the rules so now you got to get it under the rules for the bankruptcy code. So that relates to bankruptcy and the publication 908 bankruptcy tax guide for help there. Number two, the cancellation takes place when you are insolvent and that basically means like you can't pay you're not able to pay the debts. So you can exclude the canceled debt to the extent you are insolvent so of course there then you have to prove that you're basically insolvent. You got to say okay well what does it mean to be insolvent and then see if you qualify for that and for that you can see publication number four eight one canceled debt for closure, repossession and abandonment. Number three, the canceled debt is a qualified form debt owed to a qualified person see Chapter 3 of Publication 225 Farmers Tax Guide. The canceled debt is a qualified real property business debt. This situation is explained later so the canceled debt is a qualified principal residence in debtness which is discharged after 2006 see the instructions for Form 982 in that instance or situation. Debt for purposes of this discussion debt includes any debt for which you are liable or which attaches to property you hold qualified real property business debt. You can elect to exclude up to certain limits the cancellation of qualified real property business debt if you make the election you must reduce the basis of your depreciable real property by the amount excluded make this reduction at the beginning of your tax year following the tax year in which the cancellation occurs however if you dispose of the property before that time you must reduce its basis immediately before the disposition so obviously if you reduce the basis of real property we're talking like real estate generally real property then that then is not good because you would rather have the basis be higher if you sell the property if you sell it for higher than the basis the difference then is going to be the gain that you'll have to be recognizing at that point cancellation of qualified real property business debt qualified real property business debt is debt other than qualified form debt that meets all of the following conditions number one it was incurred or assumed in connection with real property used in a trade or business real property used in a trade does not include real property developed and held primarily for sale to customers in the ordinary course of business number two it was secured by such real property so secured on the loan number three it was incurred or assumed at either of the following times a before January 1st 1993 B after December 31st 1992 if incurred or assumed to acquire construct or substantially improve the real property number four it is debt to which you choose to apply these rules qualified real property business debt includes refinancing of debt described in three above but only to the extent it does not exceed the debt being refinanced if you are the owner of of a disregarded entity for example a single member LLC see qualified real property business in the independent this in chapter one of publication four six eight one to see if you qualify obviously those publications can be found on the IRS website if you want to dive into more detail with it at IRS dot gov IRS dot GOV