The Tax Club Report

Is Cancellation of Debt Taxable?

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances.

When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.

 Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.  Certain debts though, such as taxes and student loans, may not be discharged in a bankruptcy proceeding.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.  You are insolvent when your total debts are more than the fair market value of your total assets.  The amount by which you are insolvent will be the maximum amount of cancelled debt that will not be considered taxable income.  Insolvency can be fairly complex to determine.
• Certain farm debts: Taxpayers who are eligible for this relief must have all of the following three qualifications:

1)       Incurred the debt directly in operation of a farm

2)      More than half your income from the prior three years was from farming

3)      The loan was owed to a person or agency regularly engaged in lending,

If you do qualify, your cancelled debt is generally not considered taxable income. The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe you qualify for this exception.

• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
• Home Foreclosure:  The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The amount excluded reduces the taxpayer’s cost basis in the home.  Losses from the sale or foreclosure of personal property, such as a residence, are not tax deductible.

 The Tax Club is committed to helping the public understand tax law and the implications on the individual.  Feel free to contact us for a free tax consultation.  We are here to help.  866-840-1829 x5438

Tags: 1099 C, Bankruptcy Laws, Cancellation of Debt Income, Tax Debt Relief, the tax club

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