Income Excluded as a Result of Cancellation of Debt

Cancellation of Debt 1099-C is a common form that taxpayers are receiving in the mail these days. This is because you either lost your house in a foreclosure, declared bankruptcy, did a loan modification or were not able to make payments on your car.

Whatever the case, it is crucial that you understand that it is very important for you to correctly report Cancellation of Debt income. I say income because that’s exactly how IRS looks at it whether you like it or not.

I previously posted what constitutes Taxable and Non-Taxable Income and in passing, I would like to mention, without sounding like a tax geek, Section 61(a) of Internal Revenue Code includes ‘Income from discharge of indebtedness’ as gross income.

It’s tax law and thus there are exceptions/exclusions. Gross income does not include debt that was discharged as a result of:

– Bankruptcy
– Insolvency
– Student Loan Forgiveness
– Qualified principal residence indebtedness

Each of these further involve limits and exceptions.

Bankruptcy

The name itself speaks for itself, if you have filed for Chapter 11 bankruptcy then forgiveness of debt is not considered income.

Insolvency

Now this is the grey area, requires some paperwork and some substantiation on the taxpayer’s part. In a sentence, your liabilities have to be more than the Fair Market Value of your assets before the debt cancellation in order for you to claim insolvency exclusion.

Example: Your auto loan was cancelled after the repossession of your vehicle in the amount of $8,000. The FMV of your total assets immediately before the discharge was $8,000 and your liabilities were $18,000. You were insolvent to the extent of $10,000 ($18,000 – $8000).

Student Loan Forgiveness

Forgiveness of student loan doesn’t mean you don’t have to report the cancelled income. In most cases, you do have to report but there is one except. If your Federal or State student loan is forgiven as a result of you engaging in certain kind of employment for a certain period of time, then you do not have income from cancellation of debt.

Qualified principal residence indebtedness

The name is confusing but all it means that the debt you incur when you buy your primary residence. The Mortgage Forgiveness Debt Relief Act of 2007 was enacted after people started defaulting on their loans in record numbers. This Act allows exclusion of income realized as a result of foreclosure on your principal residence. The maximum amount you can treat as qualified principal residence indebtedness is $2 million. I feel bad saying this but if you think you will be foreclosed on, make sure it happens before 2012 because that’s when the act expires.

No matter what your situation is, if you are having a hard time figuring out what tax liability you have, it is always a good idea to seek professional help.

IRS Resource for more information: Publication 4681