Cancellation of Debts

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Staff Writer - Angela
October 24, 2018

Credit card debt in the United States surpassed $1 trillion in the past two years. During the same time, student loan debt surpassed $1.5 trillion. If you are one of the millions of Americans affected by debt, you may negotiate to the cancellation of debts. When that happens, your canceled debt is considered as income for tax purposes, and you might have to pay taxes on that amount.

Debt Cancellation 

When the debt becomes large enough that it cannot be repaid, the borrower may be forced to negotiate with the lender for a cancellation of debt.. This can be some or all of that debt. This applies to all kinds of debt, including credit cards, student loans, medical costs, and mortgage loans, just to name a few. It also applies to certain debts for which the borrower is liable only up to the value of the property that secures the debt, such as a mortgage loan.

A debt secured by a property may be canceled when the mortgage loan is extinguished as a result of a foreclosure, repossession, voluntary return of the property to the lender, or abandonment of the property. When any debt is canceled, it is treated as a taxable income because the borrower, in essence, received money on which he or she did not previously pay taxes.

Form 1099-C

When you file for cancellation of debts and your debt is canceled, the lender will generally report the canceled debt to you and the IRS on Form 1099-C (Cancellation of Debt). Form 1099-C must be sent to you by the end of the tax year, which is Jan. 31. The form should include all the pertinent information regarding the canceled debt, including the original amount of the debt and the amount you paid. The lender has until the end of February to send a copy of Form 1099-C to the IRS.

If you do not timely receive your Form 1099-C, you should contact the lender and request a copy. Don’t assume that just because you did not receive a copy you are not obligated to report the canceled debt as income on your tax return. Even if you did not receive Form 1099-C, it is very likely that the IRS did.

Once you receive Form 1099-C, make sure you carefully review all the amounts listed on it. If you believe some of the information listed on the form is incorrect, you should promptly get in touch with the lender to correct such information. If the lender does not correct the information on Form 1099-C, you should report the amount on your tax return and also attach an explanation about why the lender’s information is incorrect.

If you are aware of a cancellation of debts during the applicable tax year but did not receive Form 1099-C, you should list any such debt on your tax return.  On the other hand, you may have received Form 1099-C even while the creditor is still trying to collect the debt or before the debt is actually canceled. If you are not sure, you should contact the lender or the creditor to verify the status of your debt and whether it has been canceled.

Does Your Debt Qualify as Taxable Income?

Not all canceled debt is considered taxable income. Listed below are several examples of exceptions and exclusions to treating the canceled debt as taxable income. If you are not sure whether your canceled debt qualifies, you should consult a tax professional.

There are several exceptions to including canceled debt as taxable income. Those exceptions include:

  • Debts that are canceled as a devise, gift, inheritance, or bequest. However, while these debts are exempt from being taxed as income, they may still be subject to estate or capital gains tax. Tax laws with regard to inheritance and taxation differ from state to state. As such, you may want to consult a financial advisor or a tax professional.
  • Specific cancellations of student loans. For example, certain types of loans provide that they may be forgiven after a certain period of time, such as after government or public work for a period of 10 years. Once the given period passes, the subject debt is forgiven.
  • Debt that would have been a deductible expense. An example is if your mortgage lender cancels the remaining mortgage debt on your home, but part of the forgiven debt was the interest amount you could have deducted on your tax return if you paid it. The amount of interest would not need to be included as income on the tax return.

There are also certain canceled debts that may be excluded from gross income. If you claim one of the exclusions, you need to complete and attach Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) to your tax return. The exclusions include:

  • Debt canceled in a Title 11 bankruptcy. Any debt discharged in a Title 11 bankruptcy need not be reported as income on your tax return. However, if you received Form 1099-C before the bankruptcy discharge, you may still need to report the canceled debt because it is considered an income, not a debt, and therefore would not be discharged in the Title 11 bankruptcy.
  • Debt canceled during insolvency. You are considered to be insolvent if the value of your total liabilities is greater than the value of your total assets. If you are insolvent, you may reduce the amount of taxable income you report on your tax return from the canceled debt by the amount of the insolvency.
  • Cancellation of qualified farm indebtedness, qualified real property business indebtedness, or qualified principal home indebtedness.

If You Are Not Sure Your Canceled Debt Qualifies as Taxable Income

Cancellation of debts is a complicated process, and whether canceled debt qualifies as taxable income depends on a variety of factors. Different types of debt may have various tax treatments. If you fail to correctly report the taxable amount of the canceled debt, or if you fail to pay taxes on any taxable amount, the IRS may assess additional penalties, tax, or interest. Accordingly, if you are unsure of how to treat your canceled debt on the tax return, you should consult a tax professional.

 

 

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