August 08, 2018
What is Canceled Debt Income?
If a creditor forgives, or even reduces, a debt that you owe, the forgiven debt or amount of reduced debt is considered a “canceled debt.” In most instances, federal tax laws consider this amount to be income, and as a result the debtor is taxed on the amount of the canceled debt. Information regarding the amount of canceled debt is reported to the I.R.S. via Form 1099-C. The I.R.S. reports that approximately two million 1099-C forms are issued to the I.R.S. annually.
Canceled Debt That is Taxable
When a lender cancels or forgives a debt, the canceled amount is treated as income to the debtor. This is due to the fact that the debtor effectively received income, as they did not have to pay back the incurred liability. "Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income." (Source: I.R.S. Publication 525) Debt forgiveness is reported by the lender using Form 1099-C, Cancellation of Debt. Individuals report the forgiven debt on their Form 1040, Line 21 as other income.
How to Report Canceled Debt
If the debt is a non-business debt, report the canceled amount on line 21 of Form 1040. If it is a business debt, report the amount on Schedule C or Schedule C-EZ (Form 1040), on Schedule F, Profit or Loss From Farming (Form 1040) if you are a farmer, or in the appropriate “other income” sections for business entities filing Forms 1065, 1120, or 1120-S.
Interest Included in Canceled Debt
More often than not, a canceled debt will include interest in addition to the initially owed principal. If any interest is forgiven, and if the interest amount is included in the total amount of canceled debt in Box 2 of Form 1099-C, the amount of interest will often be shown in Box 3 as part of the total canceled debt. In some instances, however, Box 3 should not include the interest portion of the canceled debt.
Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible if you paid it. If the interest would not be deductible (such as interest on a personal loan), include it in your income. If the interest would be deductible (such as on a business loan), include in your income only the net amount of the canceled debt (the total amount forgiven shown in Box 2 less the interest amount shown in Box 3).
Common Situations Involving Form 1099-C
a. Payment in Full
If you settle a debt as "paid in full," meaning that the creditor agrees to accept a lower amount than what you owe for satisfaction of the total debt, then the difference between what was paid and what was owed will usually be taxed as earned income.
b. Discounted Mortgage Loan
If your financial institution offers a discount for the early payment of your mortgage loan, the amount of the discount is canceled debt. You must include the canceled amount in your income.
While this is generally true for mortgages, canceled debt on a mortgage for your personal residence may be exempt. In 2007, the Mortgage Forgiveness Debt Relief Act was passed. This act allowed taxpayers to exclude from income debt forgiven on their principal residence if the balance of their loan was $2 million or less. The limit is $1 million for a married person filing a separate return. Although this act initially only applied to tax years 2007, 2008, and 2009, an extension on the act was passed in 2008, allowing for this exception to continue through 2012. This act also survived the fiscal cliff cuts, and thus has been extended for at least another year through 2013. Currently, no legislation has been passed to extend this exclusion beyond 2013.
Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. In most cases, eligible homeowners only need to fill out a few lines on Form 982 (specifically, lines 1e, 2 and 10b).
The debt must have been used to buy, build, or substantially improve the debtor's principal residence and must have been a debt that is secured by the residence. Any debt used to refinance qualifying debt is also eligible for this exclusion, but only up to the amount of the old mortgage principal prior to refinancing.
This exception does not apply to debts forgiven on second homes, rental properties, or business properties.
c. Stockholder Debts
If the debtor is a stockholder in a corporation and the corporation cancels or forgives the debt owed to it by the stockholder, then the canceled debt is dividend income to the debtor.
On the other hand, if the debtor is a stockholder in a corporation and the corporation cancels a debt owed to the stockholder by the corporation, then this is generally not realized income. This is due to the fact that the canceled debt is classified as a contribution to the corporation’s capital; this contribution is equal to the amount of debt principal that was canceled.
d. Student loans
Some student loans contain provisions which specify that all or part of the debt incurred will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers. You do not have income if your student loan is canceled after you agreed to this provision and then performed the services required.
To qualify, the loan must have been made by:
i. The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof,
ii. A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or
iii. An educational institution that is under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or
iv. As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization.
A loan which refinances a qualified student loan will also qualify if it was made by an educational institution or a tax-exempt 501(a) organization under its program designed as described in subsection four (iv) above.
There are several general instances in which canceled debt is not to be included in reported income. Canceled debts are not included in gross income in the following situations:
a. Debts that are canceled in a bankruptcy case under title 11 of the U.S. Code are not included in gross income.
b. Debts that are canceled when the debtor is insolvent are not included in gross income. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent.
c. Debts that are qualified farm debts and are canceled by a qualified person are not included in gross income. See chapter 4 of Publication 225, Farmer's Tax Guide.
d. Debts that are qualified real property business debts. See chapter 5 of Publication 334.