In these troubled economic times, many financially distressed borrowers have had some or all of their debt cancelled or forgiven by their lender last year. While that was no doubt a welcome relief to the people who received it, they may not have realized that the amount of the forgiven debt may have to be included in income.
However, not all canceled debts trigger taxable income. And, even if there is no exception or exclusion in a particular case, the tax bite may be reduced or eliminated if you can show that the amount reported by the lender is incorrect.
General rule. The tax laws specifically include income from the discharge of indebtedness in gross income. However, there are several exceptions to this rule and numerous exclusions from gross income for certain types of forgiven debts.
Exceptions. If the cancellation of debt by a private lender, such as a relative or friend, is intended as a gift, there is no income. Likewise, a debt cancelled by a private lender’s Last Will and Testament triggers no income to the borrower.
There is also an exception for certain student loans. For example, doctors, nurses, and teachers who agree to serve in rural or low-income areas in exchange for cancellation of their student loans won’t have income from the cancellation if they meet certain conditions.
Also keep in mind that there is no income from cancellation of a debt that was deductible. For example, if a lender cancels home-mortgage interest that could have been claimed as an itemized deduction on Schedule A of Form 1040, there is no tax problem to contend with.
Price adjustment. There is no income if an individual purchases property and the seller later reduces the price. Instead, the purchaser’s basis—the yardstick for measuring gain or loss when the property is sold—is reduced by the amount of the purchase-price adjustment.
Exclusions. In addition to the above exceptions, there are exclusions from the general rule of reporting canceled debt as income for:
- discharge of debt through bankruptcy,
- discharge of debt of an insolvent taxpayer,
- discharge of “qualified farm debt,”
- discharge of “qualified real property business debt,” and
- discharge of “qualified principal residence debt.”
These exclusions are complicated, and a detailed discussion of them is beyond the scope of this letter. However, it is worth pointing out that the qualified principal residence debt exclusion applies where individuals restructure their acquisition debt on a principal residence, lose their principal residence in a foreclosure, or sell a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance). Also, the exclusions require certain tax attributes to be reduced and must be reported to the IRS on its Form 982.
Repurchased business debt. Income from certain business debt repurchased in 2009 or 2010 can be stretched out over several years. Although the debt discharge income will eventually be recognized, you benefit by deferring tax to later years.
Form 1099-C. A taxpayer should receive a Form 1099-C, Cancellation of Debt, from a financial institution, credit union, or federal government agency that forgives a debt of $600 or more. The amount of the canceled debt is shown in box 2. Any forgiven interest included in the amount of canceled debt in box 2 will also be shown in box 3. As noted above, if the interest would otherwise be deductible, it does not have to be included in income.
An individual who disagrees with the amount shown on Form 1099-C should contact the lender in writing and ask for a corrected Form 1099-C. Even if the lender refuses, you may still have recourse if you can document the correct amount of canceled debt.
If you had a debt forgiven last year, we can determine how it may affect your taxes, make sure you gain maximum advantage from any exception or exclusion that may apply, and guide you through various choices that may be available in your situation. We also may be able to help you to resolve any discrepancy over the amount reported by the lender.
