Canada: CANADIAN TAX LAWYER DISCUSSION OF DEBT FORGIVENESS: How To Utilize Gains On Settlement Of Debt, Mortgage Foreclosure & Default Sales In A Tax Efficient Manner

Last Updated: March 14 2019
Article by David Rotfleisch

Introduction – cashless income creates collection problems

Various commercial events will result in realization of income for the purposes of the Income Tax Act. Occurrences such as the settlement of a debt for less than full repayment creates an economic windfall for those receiving the debt relief. This gain is treated as income for the purposes of Canadian income taxation, however this obviously poses a problem for those in such situations. Many individuals and corporations who face this type of income inclusion are in poor financial straits. Any increase in tax liability only deepens the financial troubles of these tax payers. To compound the problem further, this type of income does not result in a cash inflow for the taxpayer, and so the ability to actually make a payment on one's tax debts is not improved despite the economic gain. Luckily the Income Tax Act does provide a mechanism to give the taxpayer some deferral of the payment.

Application of Section 80(1) – Debt Forgiveness Rules

In the case of a debt obligation, or interest amount payable, being settled or extinguished the tax payer will adjust the 'tax attributes' of the taxpayer in accordance with the sequential order of Section 80(3) through 80(13) of the Income Tax Act. 'Tax attributes' refers to items of the taxpayer's tax filings such as carried over losses of a capital or non-capital nature, the adjusted cost base of property, and other specified attributes. The forgiven debt must be applied to the maximum extent possible to each class of attributes before it may be applied to a subsequent attribute class made available by the provision in the Act.

Should any residual amount of the debt forgiveness remain after applying an amount to all of the available tax attributes of the taxpayer, half of the remainder is included in the taxpayer's income in the year of the settlement. The effect of these provisions is to treat the recognition of the gain in a deferred way, by delaying the application of the tax to the gain until the various attributes trigger the normal tax treatment. For example, by reducing the adjusted cost base of a capital property, the capital gain applicable to the disposition of that property is increased. However, the timing of the inclusion of the capital gain as a part of the taxpayer's return will still occur at the time of the disposition rather than the year of the settlement of debt.

Caution: Leave Interpretation to the Tax Lawyers

These rules are worded in a very technical manner and there application to any given taxpayers situation is best not left to the ordinary tax payer. If you are unsure as to whether you have tax attributes that qualify for this provision or are unsure as to whether you have tax attributes that must be included, it is imperative that you seek legal advice from an experienced Canadian tax lawyer.

Default Sale & Mortgage Foreclosures

Unlike other types of debt forgiveness, mortgage foreclosure has its own specific set of provisions for its tax treatment. Many people and businesses purchase property through mortgage financing. A mortgage is of course the secured lending transactions where the lender will forward to the borrower the purchase funds (usually less some amount of deposit or down payment by the borrower) in order to acquire the property. Over time the borrower many find themselves in a position where they are unable to make the regular payments. The lenders in some situations may decide to foreclose on the property, meaning that the lender has exercised their security on the property and taken possession of title.

For tax purposes, the borrower is deemed by section 79 of the Income Tax Act to have disposed of the property in exchange for proceeds equal to the amount of principle outstanding on the mortgage at the time of the foreclosure. For the borrower, this treatment potentially results in two different types of income. If the borrower has been using the property in the process of earning business income and had previously claimed a capital cost allowance on the property (assuming it is an eligible depreciable property) then the taxpayer will have both a capital gain consideration and a recapture of capital cost allowance inclusion. The recapture of capital cost allowance is included as business income, which will result in a greater amount of tax as a result of the foreclosure.

Taxpayers which have not claimed capital cost allowance on the property, or where the property is not eligible for capital cost allowance, will only have a capital gain included in their income as a result.

Repayment of the debts after the seizure of the property occurs is treated as a 'repayment of assistance' where subsections 39(13), 20(1), 66.1(5) & (6) of the Income Tax Act apply.

Under this provision, the creditor is deemed to have acquired, or reacquired, the property for a cost base equal to the amount outstanding by the debtor, less any previously claimed reserves for bad debts.

Tax Tip – An Experienced Canadian Tax Lawyer Will Know How to Treat Your Property

The reality of the tax laws in Canada is that a very complex set of rules may apply to seemingly simple transactions. In the case of extinguishing debts, the rules are particularly difficult to interpret for the average Canadian. For this reason a lawyer experienced in Canadian tax law is your best, and potentially only, bet for ensuring you are filing properly in the year of settlements. In hiring a Canadian tax lawyer to ensure proper filing positions not only will you avoid potential penalties, you will is also potentially benefit by ensuring a deferral of the taxes that comes at those times where it is needed most.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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