It’s my annual “Taxes from A to Z” series! The series focuses on terms that you might see on your tax forms and statements but not necessarily in the headlines. If you’re wondering whether you can claim wardrobe expenses or whether to deduct a capital loss, you won’t want to miss it.
C is for canceled debt.
One of the trickiest areas of income to navigate at tax time is cancellation of debt. This happens when you can’t pay what you owe (for example, a large credit card balance), and the lender (typically, a bank) agrees to discharge all or part of the debt. It could be the result of a negotiation (where you agree to pay less than you owe for the lender to leave you alone) or a default. Either way, the result is the same: the lender has forgiven some (or all) part of your debt.
For reporting purposes, a creditor will issue a form 1099-C, Cancellation of Debt (downloads as a PDF), following an identifiable event if the amount in question is $600 or more. The identifiable event is determined by the creditor and is usually when the creditor believes that they will not be able to collect what is owed to them.
The amount reported on the form 1099-C is the amount that has been forgiven, not the original amount owed. That amount is treated as income unless you meet an exclusion or exemption.
(For more details on the form 1099-C, including how to report it on your tax return, click here.)
Fortunately, there are a lot of exceptions and exclusions to the cancellation of debt as income rule. Exceptions are those events that do not result in cancellation of debt income. Exclusions are those events that would be considered cancellation of debt but are not includible in income.
Exceptions to cancellation of debt income include:
- Amounts canceled as gifts or inheritances (for example, if you owed your dad money at his death and his will stated that the amount you owed was forgiven as part of your inheritance).
- Certain qualified student loans canceled because you agreed to work for a period of time in a particular profession (such as a student loan which you don’t have to repay if you teach or practice medicine in certain areas)
- Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, paid it (meaning that if you reported the income, you would have simultaneously deducted it: it’s a wash)
- A qualified purchase price reduction which is given by the seller of property to the buyer (so, a sale)
- Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program
The most common exclusions include bankruptcy, insolvency, and qualified principal residence indebtedness:
- If your debt was canceled as part of a Title 11 bankruptcy (includes Chapters 7, 11, and 13), it’s not includible in your income.
- If, just before your debt was canceled, you were insolvent, you can exclude the debt from income.
- If your canceled debt is qualified principal residence indebtedness (a mortgage that you took out to buy, build, or substantially improve your main home, it’s not includible in income. Take note: this provision expired at the end of 2016. That means it still applies for the tax year 2016 (which you report and file) in 2017 but not for the tax year 2017 (which you report and file in 2018).
These exclusions can be tricky, and you may need to consult with your tax professional.
For more Taxes A to Z, check out: