Cary is experiencing cash flow problems during the current year. Rather than foreclose on an $80,000 business loan, his bank agrees to reduce the debt to $50,000. Prior to the debt reduction, Cary's total assets were $500,000 and his total liabilities were $510,000. How much income must Cary recognize from the reduction of his bank loan?

Question

Quizplus · Accepted Answer

Cary must recognize $30,000 of income from the reduction of his bank loan. This is because the loan amount was reduced from $80,000 to $50,000, resulting in a $30,000 reduction in his liability. Since Cary was insolvent before the debt reduction (liabilities exceeded assets by $10,000), he must recognize income to the extent that the debt forgiveness exceeds his insolvency amount. However, in this case, the entire $30,000 contributes to his income because it does not exceed his insolvency amount, thus directly affecting his net worth.

Cary Is Experiencing Cash Flow Problems During the Current Year