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Cancellation of Debt

Depending on your specific circumstances, for tax purposes, you may have to include the cancelled amount in income if you borrow money and the lender cancels or forgives the debt later on. Borrowing the money means you were obligated to repay the lender, but you were not required to include the loan proceeds in income. So when that obligation to repay the lender is forgiven, the amount you received as loan proceeds is typically reportable as income. The lender is usually required fill out Form 1099-C, Cancellation of Debt,which reports the amount of the canceled debt to you and the IRS.

Cancellation of Debt Income Is Not Always Taxable

Though Cancellation of Debt is not always taxable, there are some exceptions. Here are the most common situations:

  • Qualified principal residence indebtedness: This exception was created by the Mortgage Debt Relief Act of 2007. It applies to most homeowners.
  • Bankruptcy: Debts that are discharged because of bankruptcy are not considered taxable income.
  • Insolvency: According to the IRS “you are insolvent when your total debts exceed the total fair market value of all of your assets.  Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.”Some, or all of the cancelled debt may not be taxable to you if you are considered insolvent when the debt is cancelled.
  • Certain farm debts: If you incurred the debt directly from the operation of a farm and more than half your income from the prior three years came from farming, and the loan was owed to a person or agency that regularly engaged in lending, your cancelled debt is typically not considered taxable income.

Non-recourse loans: With a non-recourse loan the lender’s only available course of action during a default situation is to repossess the property being financed or used as collateral. Meaning the lender cannot pursue you directly in case of default. The forgiveness of debt on a non-recourse loan that results from a foreclosure does not result in cancellation of debt income, but it may result in other tax consequences.

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