Is a Cancellation of Debt Good or Bad for Taxes?

Most people base their total income on money they received during the tax year, not realizing that such an accounting often omits secondary types of income. A secondary type of income, such as a cancellation of debt, is one where income is attributed to a taxpayer even if no money changes hands. If your lender forgives more than $600 of your debt, then it is considered income. Such discharges tend to have a negative impact on taxpayers at tax time.

Definition

Any time a lender forgives a debt for which you are liable, it becomes a cancelled debt. Cancelled debts are treated as income by the IRS and are reported to you on form 1099-C. The loan is not initially considered income because there is an obligation to repay it, but once a taxpayer defaults on that obligation, it is considered taxable income. So even though no actual cash is exchanged, the IRS treats the cancelled debt as ordinary income. Once the debt is discharged, it is reported on form 1099-C.

Implications

Since canceled debt is treated as income, it increases your overall tax liability which inevitably increases the amount of tax you're responsible for paying. This could leave you with a substantial tax bill at tax time. A cancellation of debt has no positive impact on your taxes whatsoever since there are no credits or deductions associated with the cancellation of debt.

Exceptions

Debt forgiven on your principle home between the years of 2007 and 2012 is forgiven as part of the Mortgage Forgiveness Debt Relief Act of 2007. As part of the act, taxpayers are allowed to exclude up to $2 million -- $1 million if married filing separately -- of their forgiven debt. In addition, any debt which is forgiven as a gift is excludable as income. For example, some government student loan programs agree to cancel the debts of graduates if they teach at a qualified school for a set period of time. If you are a participant in a program which forgives your debt in exchange for public service, then the canceled debt is not required to be included on your tax return as income. Similarly, your cancelled debt isn't considered income if it is discharged as the result of a bankruptcy proceeding.

Filing

You are required to include the amount indicated on form 1099-C as income on your income tax return. If you receive a 1099-C that you believe to be incorrect, contact the lender directly. If, however, you believe the cancellation of debt is non-taxable, complete form 982 explaining why you believe the amount listed is not taxable and mail it to the IRS.

References

• "Forbes.com"; Ten Things to Know About COD Income; Robert Wood; February 2010
• IRS.gov; The Mortgage Forgiveness Debt Relief Act and Debt Cancellation; May 2009
• IRS.gov; Home Foreclosures and Debt Cancellation; December 2008
• IRS.gov; Topic 431 -- Canceled Debt -- Is it Taxable or Not?; March 2011
• Department of the Treasury; Publication 4681: Canceled Debt, Foreclosures, Repossessions and Abandonments; 2010