Tax Rules for Cancellation of Debt

You may be responsible for taxes on your cancelled debt.
You may be responsible for taxes on your cancelled debt. (Image: debt defined image by Christopher Walker from <a href=''></a>)

The IRS has rules for any and every type of income a person might earn. One type of income that has become increasingly common in these days of economic downturn is the Cancellation of Debt income. Cancellation of Debt income is generated when a creditor "forgives" an amount of debt owed by an individual.

How Cancellation of Debt Works

A debt is canceled when a bank, credit card company or lender "forgives" an amount owed by a taxpayer when there has been a repossession (in the case of a vehicle, furniture or appliances) or a foreclosure (in the case of a home or other type of residence). The amount of whatever debt is owed by the taxpayer is then reported in Box 2 of Form 1099-C. Even though the taxpayer never received this amount in cash or any other tender, the IRS considers canceled debt as ordinary income to be taxed. If the property that has been used as collateral has been abandoned, it may be necessary for the lender to file a 1099-A for abandoned property.

When Is Cancellation of Debt Income Not Taxable?

There are a number of exceptions to the rule about the taxation of canceled debt income. The exceptions include any debts discharged in bankruptcy, providing the debt was discharged prior to the 1099-C being issued. Another exception is insolvency. If at the time of the issuing of the 1099-C, the taxpayer has more total debts than the fair market value of his total assets, the taxpayer is considered insolvent.

Certain farm debts that have been canceled are considered non-taxable. If the debt was for the purpose of operating a farm, and the taxpayer earned more than half of her income from the operation of that farm, the canceled debt may not be taxable.

Non-recourse loans are loans that, if canceled, leave the lender unable to pursue the taxpayer individually, as the taxpayer has secured the debt with the collateral of the house or land purchased. So a cancellation of debt from a non-recourse loan won't result in cancellation of debt income, but it may result in other tax consequences.

Gains or Losses Can Result in Cancellation of Debt Income

Most individuals who are in a position where they have received a 1099-C are already in a precarious financial position and are not able to pay the taxable portion of an amount of money they never received. This is the case especially in repossessions and foreclosures.

It is possible for there to be a gain made from the foreclosure. Take the fair market value of the home being foreclosed on. Calculate what the IRS calls the "adjusted basis," which includes your purchase price plus the costs of any home improvements. Subtract this amount from the fair market value, and the result will be the gain in the foreclosure.

If there has been a loss on the foreclosure, which happens when the debt owed is greater than the fair market value of the home, that loss cannot be deducted from taxable income.

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