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Canceled debt arises if you are liable for a debt that is canceled, forgiven, or discharged. Generally, you will receive a Form 1099-C (PDF), Cancellation of Debt, and must include the canceled debt amount in gross income. However, certain exclusions and exceptions may apply. If you receive a Form 1099-C but the creditor is continuing to try to collect the debt, then the debt has not been cancelled and you do not have taxable canceled debt income.
A debt includes any indebtedness whether you are personally liable or liable only to the extent of the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, a repossession, a voluntary return of the property to the lender, abandonment of the property, or a principal residence loan modification. If your debt is secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you are treated as having sold that property and may have a taxable gain or loss. The gain or loss on such a deemed sale of your property is an issue separate from whether any cancellation of debt income associated with that same property is includible in gross income.
You must report any taxable amount of a cancelled debt for which you are personally liable, as ordinary income from the cancellation of debt, on Form 1040 or Form 1040NR and associated schedules, as advised in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals). You must report the taxable amount of a canceled debt whether or not you receive a Form 1099-C.
One might ask why is canceled debt considered taxable income? The theory behind the taxation of canceled debt is that there is an economic gain or increase in wealth on the part of the taxpayer. For example, assume the taxpayer receives a $300,000 loan. The loan proceeds are not taxed upon borrowing. Assume further that the lender forgives$200,000 some time in the future. Taxpayer/debtor “received” $200,000 of wealth without tax consequence. Lender issues Form 1099-C showing $200,000 of canceled debt income.
IRS will be expecting to see this income on the tax return unless, under Code Section 108, there is an exception. Canceled debts that meet the requirements for any of the following exceptions or exclusions are not taxable.
Canceled Debt that Qualifies for EXCEPTION to Inclusion in Gross Income:
- Amounts specifically excluded from income by law such as gifts or bequests
- Cancellation of certain qualified student loans
- Canceled debt, that if paid by a cash basis taxpayer, would be deductible
- A qualified purchase price reduction given by a seller
- Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program
Section108(f)(1) excludes student loan discharge if such discharge is pursuant to a provision of such loan under which all or part of the indebtedness would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of employers. Professions included in this class are teachers, child care workers, special education teachers and armed forces. Service cannot be for the institution that issued the loan, however.
Section 108(e)(2) covers loans made in connection with a business. No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a business deduction. For example, ABC Co. borrows $1,000 to conduct an advertising campaign. Since advertising is a deductible business expense, cancellation of the $1,000 debt would not result in recognition of income from debt cancellation.
Canceled Debt that Qualifies for EXCLUSION from Gross Income:
- Debt canceled in a Title 11 bankruptcy case
- Debt canceled during insolvency
- Cancellation of qualified farm indebtedness
- Cancellation of qualified real property business indebtedness
- Cancellation of qualified principal residence indebtedness
The exclusion for “insolvency” is determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge. Assets are valued at fair market value. If there is an excess of liabilities over assets, the difference is the amount of insolvency.
The exclusion for “qualified principal residence indebtedness” provides tax relief on canceled debt for many homeowners involved in the mortgage foreclosure crisis. The exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of “qualified principal residence indebtedness.”
Generally, if you exclude canceled debt from income under one of the exclusions listed above, you must reduce your positive tax attributes (certain credits, losses, basis of assets, etc.), within limits, by the amount excluded. You must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the amount qualifying for exclusion and any corresponding reduction of certain tax attributes.
If you received a Form 1099-C and the information is incorrect, contact the lender to make corrections.
There is a great deal of information regarding cancellation of debt income which is misunderstood. Be sure to contact a professional who is knowledgeable in this area.
For more information regarding taxability of canceled debt, how to report it, and related exceptions and exclusions, complete the form below.
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