Is Canceled Debt Taxable?
2016-12-06 | by Gene Reynolds
Generally, debt that is forgiven or canceled by a lender is considered taxable income by the IRS and must be included as income on your tax return. Examples include a debt for which you are personally liable such as mortgage debt, credit card debt, and in some instances, student loan debt.
When that debt is forgiven, negotiated down (when you pay less than you owe), or canceled you will receive Form 1099-C, Cancellation of Debt, from your financial institution or credit union. Form 1099-C shows the amount of canceled or forgiven debt that was reported to the IRS. If you and another person were jointly and severally liable for a canceled debt, each of you may get a Form 1099-C showing the entire amount of the canceled debt. Give the office a call if you have any questions regarding joint liability of canceled debt.
Creditors who forgive $600 or more of debt are required to issue this form. If you receive a Form 1099-C and the information is incorrect, contact the lender to make corrections.
If you receive a Form 1099-C, don’t ignore it. You may not have to report that entire amount shown on Form 1099-C as income. The amount, if any, you must report depends on all the facts and circumstances. Generally, however, unless you meet one of the exceptions or exclusions discussed below, you must report any taxable canceled debt reported on Form 1099-C as ordinary income on:
- Form 1040 or Form 1040NR, if the debt is a nonbusiness debt;
- Schedule C or Schedule C-EZ (Form 1040), if the debt is related to a nonfarm sole proprietorship;
- Schedule E (Form 1040), if the debt is related to non-farm 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.
Exceptions and Exclusions
If you had debt forgiven or canceled last year and receive a Form 1099-C, you might qualify for an exception or exclusion. If your canceled debt meets the requirements for an exception or exclusion, then you don’t need to report your canceled debt on your tax return. Under the federal tax code, there are five exceptions and four exclusions. Here are the five most commonly used:
Note: The Mortgage Debt Relief Act of 2007, which applied to debt forgiven in calendar years 2007 through 2014, allowed taxpayers to exclude income from the discharge of debt on their principal residence. The PATH (Protecting Americans from Tax Hikes) Act extended this relief through the end of 2016.
Up to $2 million of forgiven debt was eligible for this exclusion ($1 million if married filing separately) and debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, also qualified for the relief.
1. Amounts specifically excluded from income by law such as gifts, bequests, devises or inheritances
In most cases, you do not have income from canceled debt if the debt is canceled as a gift, bequest, devise, or inheritance. For example, if an acquaintance or family member loaned you money (and for whom you signed a promissory note) died and relieved you of the obligation to pay back the loan in his or her will, this exception would apply.
2. Cancellation of certain qualified student loans
Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. If your student loan is canceled as the result of this type of provision, the cancellation of this debt is not included in your gross income.
3. Canceled debt, that if it were paid by a cash basis taxpayer, would be deductible
If you use the cash method of accounting, then you do not realize income from the cancellation of debt if the payment of the debt would have been a deductible expense.
For example, in 2015, you obtain accounting services for your farm using credit. In 2016, due to financial troubles you were not able to pay off your farm debts and your accountant forgives a portion of the amount you owe for her services. If you use the cash method of accounting you do not include the canceled debt as income on your tax return because payment of the debt would have been deductible as a business expense.
4. Debt canceled in a Title 11 bankruptcy case
Debt canceled in a Title 11 bankruptcy case is not included in your income.
5. Debt canceled during insolvency
Do not include a canceled debt as income if you were insolvent immediately before the cancellation. In the eyes of the IRS, you would be considered insolvent if the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation.
For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account).
Here’s an example. Let’s say you owe $25,000 in credit card debt, which you are able to negotiate down to $5,000. You have no other debts and your assets are worth $15,000. Your canceled debt is $20,000. Your insolvency amount is $10,000. Because you are insolvent at the time of the cancellation, you are only required to report the $10,000 on your tax return.
If you exclude canceled debt from income under one of the exclusions listed above, you must reduce certain tax attributes (certain credits, losses, basis of assets, etc.), within limits, by the amount excluded. If this is the case, then 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 those tax attributes.
Exceptions do not require you to reduce your tax attributes.
Don’t hesitate to call if you have any questions about whether you qualify for debt cancellation relief.
About the Author
Gene is the Founder and President of Reynolds and Associates, a Houston-based CPA Firm. He has spent 42 years helping Houston entrepreneurs navigate their enterprises thru both calm and stormy waters.