Cancellation of Debt

Cancellation of Debt: When Does Forgiven Debt Become Taxable Income?

When a creditor forgives or cancels a debt you owe, it might sound like a financial miracle, but the IRS often considers that forgiven amount as taxable income.

What is Cancellation of Debt (COD)?

Cancellation of Debt (COD) refers to a situation where a lender or creditor legally forgives or cancels a debt that a borrower owes. This can happen for various reasons, such as a lender deciding to write off an uncollectible debt or as part of a loan modification or settlement.

Background

In the past, if a creditor forgave a debt, the borrower usually had to pay income tax on the amount forgiven. This often created a difficult situation for individuals or businesses facing financial hardship, as they were hit with a tax bill on money they never actually received.

Recognizing this problem, Congress introduced specific provisions in tax law to provide relief in certain situations. The Bankruptcy Tax Act of 1980 and the Income Tax Act of 1984 were key pieces of legislation that introduced exclusions for COD income in cases of bankruptcy and insolvency.

How Does Cancellation of Debt Work?

When a debt is canceled, the creditor may issue IRS Form 1099-C, “Cancellation of Debt,” to both the borrower and the IRS. This form reports the amount of debt that was forgiven.

Generally, if you are a debtor and a creditor cancels or forgives your debt, you must include the canceled amount in your gross income for tax purposes. However, there are several exceptions where COD income is not taxable. These exceptions often apply when the debt is canceled due to:

• Bankruptcy: If a debt is discharged in a Title 11 bankruptcy case, it is not considered taxable income.
• Insolvency: If you are insolvent (meaning your total debts exceed the fair market value of your assets), the amount of debt forgiven up to the point of insolvency is not taxable.
• Certain Farm Debts: Specific rules apply to the forgiveness of certain farm-related debts.
• Certain Residential Mortgage Debt: Through 2025, qualified principal residence indebtedness (like your primary home mortgage) that is canceled or forgiven may be excluded from income.

Real-World Examples

• Credit Card Debt: If you owe $10,000 on a credit card and the credit card company agrees to settle the debt for $5,000, the remaining $5,000 is canceled debt. If you don’t qualify for an exception, you’ll likely owe income tax on that $5,000.
• Student Loans: Many federal student loan programs offer forgiveness options, such as Public Service Loan Forgiveness (PSLF). If you meet the program’s requirements, the forgiven loan balance is typically not taxed. However, private student loans canceled outside of specific programs may be treated as taxable income.
• Mortgage Debt: If you owed $300,000 on your mortgage, sold your home in a short sale, and the lender forgave $30,000 of the debt, that $30,000 might be excludable from your income if it qualifies as canceled principal residence indebtedness.

Who is Affected by Cancellation of Debt?

Cancellation of debt can affect any individual or business that owes money and has a portion of that debt forgiven by a creditor. This includes:

• Individuals with credit card debt, personal loans, or mortgages.
• Students with student loan debt.
• Business owners with business loans or lines of credit.

Tips and Strategies

• Understand the Exceptions: Familiarize yourself with the exceptions to COD income, especially if you are going through bankruptcy, are currently insolvent, or have had a mortgage canceled.
• Keep Good Records: Maintain copies of all relevant documents, including loan agreements, settlement letters, bankruptcy filings, and IRS forms like Form 1099-C.
• Consult a Tax Professional: The rules surrounding COD income can be complex. It’s highly recommended to consult with a qualified tax advisor or CPA to understand how forgiveness of debt impacts your specific tax situation and to ensure you are meeting all reporting requirements.
• Negotiate Carefully: If you’re settling a debt, try to get the agreement in writing and clarify whether the forgiven amount will be reported as COD income.

Common Misconceptions

• “All forgiven debt is taxable income.” This is not true. As mentioned, there are significant exceptions, such as bankruptcy and insolvency.
• “If I don’t get a 1099-C, I don’t owe taxes on it.” Even if a creditor doesn’t issue a 1099-C, you may still have taxable COD income if an exception doesn’t apply. It’s your responsibility to report it correctly.

Sources:

• Cancellation of Debt (Section 108) (IRS)
• Form 1099-C, Cancellation of Debt (IRS)
• Discharge of Indebtedness Income (Investopedia)
• What to Do When Debt Is Canceled (NerdWallet)