Cancellation of debt refers to a debt being cancelled, forgiven or discharged for less than the full amount of the debt. The portion of the debt that you no longer have to pay is considered cancellation of debt income (COD).
Cancellation of debt frequently occurs in conjunction with foreclosure or repossession of property, such as a car. Cancellation of debt also results from creditor negotiations or mortgage modifications. This may happen if you are having difficulty affording your loan repayments. In addition, cancellation of debt occurs if a creditor gives up on collecting a debt for any reason.
What is Debt Cancellation?
Debt cancellation, also known as debt forgiveness, occurs when a creditor relieves a borrower from a debt obligation. This can happen through various means, including negotiations with creditors, debt settlement, bankruptcy, or federal student loan forgiveness programs. When debt is canceled, the borrower is no longer responsible for paying the canceled amount. However, debt cancellation may have tax implications and can damage credit scores. For instance, while federal student loan forgiveness can provide significant relief, the forgiven amount may be considered taxable income, depending on the specific program and circumstances.
Tax Rules for Cancellation of Debt
Cancellation of debt is generally taxable. It is taxable because forgiveness of debt represents a benefit received by the taxpayer. And the IRS is going to tax that benefit.
The amount of the tax is based on the amount of debt forgiven. Canceled debt is typically included in your gross income, which can affect your overall tax liability.
1099-C and Cancellation of Debt
Your lender will usually send you Form 1099-C (sometimes called 1099c) when a debt if forgiven. This form reports the amount of cancelled debt and the date of cancellation. You are required to report the cancellation of debt stated on Form 1099-C on your tax return for the year in which the debt was cancelled.
If a debt is cancelled and you did not receive a Form 1099-C in the mail, you are still required to report the cancellation of debt on your tax return.
The IRS will receive a copy of the Form 1099-C from your lender. They will be expecting to see cancellation of debt reported on your tax return, unless an exception applies.
Form 1099-C is only required for cancellation of debt in excess of $600.
Exclusions from Cancellation of Debt Taxable Income
The IRS allows for a number of exclusions from the general tax rules for cancellation of debt. If you receive a 1099-C in the mail, be sure to check if the exclusions apply to your situation.
Here are some of the more common examples of exclusions to the tax rules for cancellation of debt:
Insolvency Exclusion
Insolvency is a financial state where an individual’s total liabilities exceed their total assets. In the context of debt cancellation, insolvency is an important concept because it can exclude canceled debt from being considered taxable income. If a borrower can demonstrate insolvency at the time of debt cancellation, they may not have to pay taxes on the canceled amount.
To qualify for the insolvency exclusion, borrowers must file Form 982 with the IRS and provide documentation to support their insolvency claim. This documentation should include a detailed calculation of the fair market value of all assets and a comprehensive list of all liabilities.
The insolvency exclusion is fairly common, especially when there is a downturn in the economy.
The determination of insolvency requires a careful calculation of the fair market value of all assets owned, such as real estate, investments, cash, furniture, vehicles, computers, jewelry and appliances. You will also need to add up all outstanding debts, such as credit card bills, mortgages, car loans and utility bills.
Be sure to keep a copy of documents that prove your insolvency in case the IRS asks any questions or audits your return. We recommend that these documents be kept for at least 7 years.
Bankruptcy Exclusion
Debt discharged as part of a bankruptcy is not taxable. This is because the IRS recognizes that individuals in bankruptcy are experiencing significant financial hardship and cannot afford to pay taxes on discharged debts. Bankruptcy can provide a fresh start for individuals overwhelmed by debt, allowing them to reorganize their financial situation without the burden of additional tax liabilities.
It is important to note that not all debts can be discharged in bankruptcy, and the process can have long-term implications on credit scores and future borrowing ability. However, for those who qualify, discharging debt through bankruptcy can be a crucial step in regaining financial stability.
You can learn more about this topic at our article on Taxes and Bankruptcy. This resource provides detailed insights into how bankruptcy can affect tax obligations and what steps individuals should take to navigate the process effectively.
Qualified Principal Residence Indebtedness Exclusion
The Qualified Principal Residence Indebtedness Exclusion allows homeowners to exclude canceled debt on their principal residence from taxable income. This exclusion was initially introduced as part of the Mortgage Forgiveness Debt Relief Act of 2007, which aimed to provide relief to homeowners facing financial hardship during the housing crisis. It applies to debt forgiven due to foreclosure or mortgage restructuring on a primary home.
The exclusion is subject to certain limitations and requirements, such as the debt being used to buy, build, or substantially improve the primary residence. Homeowners should ensure they meet all criteria to qualify for this exclusion and consult with tax professionals for guidance.
Qualified Farm Indebtedness Exclusion
The Qualified Farm Indebtedness Exclusion is designed to support farmers by excluding canceled farm debt from taxable income under specific conditions. This exclusion is applicable when the debt is directly related to the farming business and the borrower meets certain qualifications, such as deriving more than half of their gross income from farming in the previous three years.
The exclusion aims to aid farmers facing financial difficulties, allowing them to focus on maintaining and growing their agricultural operations without the added burden of tax liabilities on forgiven debt. Farmers should carefully review the criteria and work with tax professionals to ensure eligibility and compliance with IRS regulations.
Form 982
If you qualify for one of the exclusions from the cancellation of debt rules, then you must must reduce certain “tax attributes” by the amount of cancelled debt excluded from taxable income. Examples of tax attributes are net operating losses, tax credits and cost basis in property.
Reduction of tax attributes is reported on IRS Form 982. If you have debt forgiveness and took advantage of one of the exclusions, then you are required to attach Form 982 to your tax return.
IRS Audits and Form 1099-C
Expect to be audited if a lender issues you a Form 1099-C and you do not report it on your tax return. This will usually be an automated underreporting (AUR) audit. AUR audits are generated by computers that are programmed to identify discrepancies between 1099s and W-2s on the one hand and tax returns on the other hand.
Check our IRS Audit Guide for more details on this topic, including a discussion on best practices in audit defense.
Does Debt Cancellation Hurt Your Credit Score?
Debt cancellation can have mixed effects on your credit score. When a debt is canceled, it may initially appear as a negative mark on your credit report, especially if the cancellation is due to non-payment or settlement for less than the owed amount. This can lead to a decrease in your credit score, as it reflects a failure to fulfill the original terms of the debt obligation.
However, over time, the impact of debt cancellation on your credit score can diminish. As you continue to make timely payments on other debts and maintain responsible credit behavior, your score can gradually recover. It’s important to note that while the canceled debt itself may negatively impact your credit score, eliminating the debt burden can improve your overall financial health, allowing you to focus on managing remaining debts more effectively.
In some cases, working with a credit counselor or participating in a debt management plan can help mitigate the negative effects of debt cancellation on your credit score. Credit counseling can provide guidance on improving your credit profile and developing a strategy to rebuild your credit over time.
Ultimately, the extent to which debt cancellation impacts your credit score depends on various factors, including your overall credit history, the amount of debt canceled, and how you manage your credit moving forward. It’s crucial to monitor your credit reports regularly and take proactive steps to address any negative items that may arise from debt cancellation. By doing so, you can work towards restoring and maintaining a healthy credit score in the long run.
Debt Relief Programs
Debt relief programs are designed to help borrowers manage their debt and avoid financial hardship. These programs can include debt settlement, credit counseling, and debt management plans. Debt settlement companies, for example, work with creditors to negotiate a lump sum payment that is less than the total amount owed. In exchange, the creditor agrees to forgive the remaining debt.
While debt relief programs can provide much-needed relief for borrowers who are struggling to pay their debts, they may also come with fees and can negatively impact credit scores. Credit counseling, on the other hand, offers guidance on managing finances and creating a plan to pay off debt without necessarily reducing the amount owed.
Federal Student Loan Forgiveness
Federal student loan forgiveness programs are designed to help borrowers who are struggling to repay their student loans. These programs can include income-driven repayment plans, public service loan forgiveness, and teacher loan forgiveness. Borrowers who qualify for these programs may have their student loans forgiven after a certain period of time or number of payments.
For example, the Public Service Loan Forgiveness program forgives the remaining balance on Direct Loans after 120 qualifying monthly payments under a qualifying repayment plan while working full-time for a qualifying employer. Federal student loan forgiveness programs can provide significant relief for borrowers who are struggling to repay their student loans, but it is important to understand the specific requirements and conditions of each program.
Mortgage Forgiveness Debt Relief Act
The Mortgage Forgiveness Debt Relief Act is a federal law that excludes up to $2 million in forgiven mortgage debt for married couples filing jointly. The act applies to debt discharged in 2021 if there was a written agreement entered into in 2020. The Consolidated Appropriations Act extends the exclusion of canceled qualified mortgage debt from income for tax years 2021 through 2025.
____________________________
For more information about the tax and accounting services we provide, visit our Home Page! The friendly CPAs, Enrolled Agents, tax professionals, and bookkeepers and accountants at Massey and Company CPA are here to assist you.
If you want my team and I to handle your tax matter for you, click here.
You are welcome to email me directly at gary.massey@masseyandcompanyCPA.com.
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, estates and trusts, IRS tax problem resolution, IRS audits, sales taxes, small business accounting, and bookkeeping clean up services.
Check out our 5-Star Google reviews here!
