You may not always be required to pay back your debts in full.  It is not wholly uncommon for a debt to be forgiven or otherwise discharged – a creditor may fail to collect, discontinue attempts to collect or outright forgive your debt for whatever reason – thus leading to a cancellation of the debt in the amount specified.

Though cancellation of debt is largely seen as a positive result for the debtor, there may be significant tax consequences.  Barring certain legal exceptions, canceled debt must be reported on your tax return as ordinary income for the year that such cancellation was made, and is therefore taxable.

The Reporting Process

If a creditor has canceled a debt of at least $600, then they must send you a Form 1099-C indicating the canceled debt amount and the date of cancellation.  You should treat the Form 1099-C as a sort of notice of canceled debt.  If a creditor has sent a Form 1099-C but continues their attempts to collect, this should serve as a signal of conflicting information and you should follow up with the creditor to ensure that the debt has, in fact, been canceled.

Your tax liabilities are not forgiven if a creditor has been irresponsible and fails to send a correct Form 1099-C.  As such, it is your responsibility to follow up on missing, incorrect or conflicting Form 1099-C information.

If the debt canceled is a personal, nonbusiness debt, then you must report the taxable amount as ordinary income on Form 1040 (for US residents) or 1040NR (for US nonresident aliens).

Cancellation of debt income – exceptions

Not all canceled debt is technically considered cancellation of debt income, and as such, may not be taxable. If you meet any of the following requirements, then the canceled debt amount will not be considered income and is therefore not taxable.  This list is non-exhaustive.

  • Debts canceled as a gift, bequest, or as part of an inheritance.
  • Student loans where the eventual cancellation of the loan was part of the “benefit of the original bargain.”
    • For example, certain student loans provide for cancellation of the debt if the student goes on to work in nonprofit organizations for a period of years. If the student completes this term of work, the debt will be canceled.  This cancellation was part of the original loan bargain.
  • Canceled debt amounts that would have been deductible had the taxpayer paid the debt themselves.
  • Qualified purchase price adjustment of property given by the seller.

Cancellation of debt income – exclusions

If any of the following situations apply to you, then the canceled debt amount is still considered canceled debt income, but will not be included as gross income and is therefore not taxable.

  • Discharge of debt in a Title 11 bankruptcy case.
  • Discharge of debt due to taxpayer insolvency.
  • Discharge of qualified farm debt.
  • Discharge of qualified real property business debt.
  • Discharge of qualified principal residence debt.

If you were able to exclude canceled debt from your income, you must reduce certain of your tax attributes by the amount excluded. These tax attributes may include losses and loss carryovers, credits and credit carryovers and basis in assets.

If you have had debt canceled, forgiven or otherwise discharged, you cannot assume your problems are behind you.  You may be liable for significant taxes on the canceled debt income.  For Boca Raton tax debt help, contact East Coast Tax Consulting Group as soon as possible to discuss your concerns.