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.
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.
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 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: What is Insolvency?
Debts that are cancelled when a taxpayer is insolvent are not taxable. Insolvency is defined as a situation in which total debts are greater than total assets. The amount excluded by an insolvent taxpayer is limited to the amount of insolvency.
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.
You can learn more about this topic at our article on Taxes and Bankruptcy.
Qualified Farm Exclusion
The discharge of qualified farm debt is not taxable. To qualify for the exclusion, 50% of the taxpayer’s total gross receipts for the prior three tax years must be from farming.
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.
Form 1099-C and Credit Scores
Even if you qualify for one of the tax exceptions discussed above, forgiveness of debt may have a significantly negative impact on your credit score.
The 1099-C itself is not given by the lenders or the IRS to the credit reporting agencies. However, lenders do inform the agencies when required payments on a debt are late or unpaid.
You are welcome to contact our CPA firm if you received a Form 1099-C because of a cancellation of debt. This is especially important if you want to qualify for the insolvency exclusion.
Feel free to call us in Atlanta at 678-235-5460 or in Chicago at 773-828-0551. We will be happy to work with you to resolve your tax matter. We deal with the IRS so you do not have to.
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, IRS tax problem resolution, IRS audit defense, sales tax, and small business accounting and bookkeeping.
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