Is Canceled Debt Taxable?

If you have a debt that has been forgiven, erased or reduced, is that amount still taxable?  For the most part, the IRS says yes.  You must include these amounts as income when you prepare your tax return.  This refers to debts for which you alone are personally liable, for example, mortgage debt, credit card debt, and sometimes, student loan debt.  

When there is a change in the debt status – that is, when the debt is waived, canceled or when you are able to negotiate a partial payment as fulfillment of the obligation – your bank, lending institution or credit union will send you Form 1099C, Cancellation of Debt.   This form outlines the exact amount of
canceled or forgiven debt that was reported to the IRS.

If, in addition to you, there is another person who is also responsible for the debt, you will reach receive Form 1099C, with the full amount of the canceled debt.  Contact your tax professional for specific questions about joint liability of canceled debt.

If your debt is more than $600, your lender is required to submit this form.  If you do receive a Form 1099C, here’s what you should know:

First of all, never ignore such a notice.  Review it immediately, and if there is any incorrect information, contact your lender to make the necessary adjustments.

The entire amount shown on Form 1099C may not need to be reported as income.  How much of that amount must be reported depends on the specifics.  However, for the most part, you must report all taxable canceled debt reported on Form 1099C as regular income unless you meet certain exclusions.  If the exclusions explained below do not apply to you, then you should make sure to report all taxable canceled debt reported on Form 1099C as ordinary income on:

Form 1040 or Form 1040NR (if the debt is a personal, non-business debt) ;
Schedule C or Schedule CEZ (Form 1040) (if the debt is related to a nonfarm sole proprietorship) ;
Schedule E (Form 1040) (if the debt is related to nonfarm rental of real property) ;
Form 4835 ( if the debt is related to a farm rental activity for which you use Form 4835 to report
Farm rental income based on crops or livestock produced by a tenant) ; or
Schedule F (Form 1040) (if the debt is farm debt and you are a farmer).

Sidebar

In 2007, Congress passed The Mortgage Debt Relief Act, which allowed taxpayers to exclude income from the discharge of debt on their primary home residence.  This Act only applied to debt forgiven in calendar years 2007 – 2014.  

As much as $2 million of forgiven debt was eligible for this exclusion (about half that for those married couples filing separately).  Debt reduced because of mortgage restructuring, and mortgage debt forgiven during foreclosure proceedings qualified as well.  

To date, Congress has not yet reauthorized the Act for calendar year 2015.
Exceptions

Here are five exceptions that may allow you to avoid reporting your canceled debt as income on your tax return.

1. Canceled debt due to gifts, bequests, devises or inheritances

For the most part, you do not have to declare income from canceled debts if the debt was waived as a gift, bequest, devise, or inheritance.   Let’s say you borrowed money from a friend or family member, and signed a promissory note.  If that person forgives your loan as a gift, or if that person waives the obligation in a will, then you will not have to declare this amount as income.

2. Cancellation of specific qualified student loans

Some student loans have a provision which states that all or part of the debt incurred to attend a qualified educational institution will be canceled if the student works for a specified time period in certain professions for any of a broad class of employers.   Check your loan information carefully to see if this applies to you.

3. Canceled debt that would be deductible if it were paid by a cash basis taxpayer

If most of your accounting is cash-based, then you do not have to list as income money gained from the cancellation of debt — if the payment of that debt would have been a deductible expense.  Here’s an example.  Let’s say that in 2014, you hired accounting services for your farm using credit.  In 2015, because of financial troubles, you can’t pay off your farm debts.  Your bookkeeper or accountant decides to forgive a part of what you owe.  If you use the cash method of accounting, you do not need to include the canceled debt as income on your tax return, since payment of the debt would have been deductible as a business expense.

4. Canceled debt from a Title 11 bankruptcy case

Debt canceled in a Title 11 bankruptcy case is not included in your income.

5. Canceled debt canceled during insolvency

You should not include a canceled debt as income if you were insolvent immediately before the
cancellation. The IRS considers you “insolvent” if the sum total of your liabilities was more than the FMV of all of your assets, just before the debt was canceled.

When the IRS determines if you are insolvent, it looks at the value of everything you own, to determine your assets.  This includes assets that serve as collateral for your debt.  It even assets which are exempt from the reach of your creditors under the law, such as interest from your pension plan or the value of your retirement account.

Let’s look at a specific example.  Let’s say you owe $25,000 in credit card debt, and you negotiate it down to $5,000. That’s a good start.  Now, in this example, you have no other debts.  Your assets total $15,000. Your canceled debt is $20,000. Your insolvency amount is $5,000. Because you are insolvent at
the time of the cancellation, you are only required to report the $15,000 as income on your tax return.

If you qualify for one of the above listed exclusions, and you therefore exclude your canceled debt from your reported income, you must reduce certain tax attributes (specific credits, losses, basis of assets, etc.), within limits, by the amount excluded.  You will need to 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 those tax attributes.

There are certain exceptions (as opposed to the exclusions listed above) do not require you to reduce your tax attributes.  Call us/Check with your tax professional for details specific to your situation.

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