Income from the Cancellation of Indebtedness

Recent tough economic times have led some lenders and borrowers to work out debt modifications, including the cancellation or forgiveness of some or all of the debt.  The amount of the cancelled debt generally must be reported as income on your tax return.  If a financial institution forgives the debt, it is required to issue Form 1099-C, reporting the amount of the forgiveness to the IRS.  There are many specific provisions that excuse the debtor from having to pay tax on the forgiven debt.  These include the following:

• Discharge of a private debt from a relative or friend that is intended as a gift,
• Discharge of student loans of doctors, nurses and teachers who agree to serve in rural or low income areas and meet certain conditions,
• Discharge of debt that, if paid, would have resulted in a tax deduction (e.g. accrued mortgage interest expense),
• Reduction in price for the purchase of property,
• 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.

There are many complicated rules and time limits associated with these exceptions.  Most of these exceptions must be reported to the IRS on Form 982 and result in the reduction of certain tax attributes, such as the tax basis of property or the carryover of tax losses.