Financially distressed borrowers may have some or all of their debt cancelled or forgiven by a lender. While this is a welcome relief to the borrowers, they may not realize that the amount of the forgiven debt may have to be included in income.

However, not all canceled debt triggers 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 under a private lender’s will 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. And, for 2018 – 2025, where there’s a discharge of a student loan on account of the death or total and permanent disability of the student, the amount of the discharge isn’t includible in the borrower’s gross income.

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” (for discharges before Jan. 1, 2021, or under written discharge arrangements entered into through 2020).

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 the exclusion must be reported to the IRS on IRS Form 982.

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.

Categories: Cancellation of Debt Income & Exceptions, Federal Tax Articles, Tax Articles, Tax Planning/Tax Opinions