CANCELLATION OF DEBT
WHAT IS CANCELLATION OF DEBT?
If the taxpayer borrows money from a commercial lender and the lender later cancels or forgives the
debt, he may have to include the cancelled amount in income for tax purposes, depending on the
circumstances. When the taxpayer borrowed the money he was not required to include the loan
proceeds in income because he had an obligation to repay the lender. When that obligation is
subsequently forgive, the amount he received as loan proceeds is normally reportable as income
because he no longer has an obligation to repay the lender.
If a federal government agency of an applicable financial entity cancels or forgives a debt of $600 or
more, the taxpayer should receive a Form 1099-C, Cancellation of Debt, showing amounts and other
information relating to the cancellation. The amount of canceled debt is shown in Box 2 of the form.
Here’s the simplified example. The taxpayer borrows $10,000 and default on the loan after paying
back $2,000. If the lender is unable to collect the remaining debt from the taxpayer, there is a
cancellation of debt of $8,000, which generally is taxable income to the taxpayer.
Depending on the circumstance by which the taxpayer’s debt was canceled and the nature of any
property associated with the debt, the canceled debt may qualify for an exception to inclusion in gross
income, or the canceled debt may result in gross income but the income may be excluded.
Canceled Debts that meet the requirements for any of the following exceptions or exclusions WILL
NOT be taxable.
Cancelled Debt that QUALIFIES for EXCEPTION TO INCLUSION in GROSS INCOME:
Amounts specifically excluded from income by law such as gifts or bequests
Cancellation of certain qualified student loans
Cancelled debt that if paid by a cash basis taxpayer is otherwise deductible
A qualified purchase price reduction given by a selleR
Cancelled Debt that Qualifies for EXCLUSION from GROSS INCOME:
Cancellation of qualified principal residence indebtedness
Debt cancelled in a Title 11 bankruptcy case
Debt canceled due to insolvency
Cancellation of qualified farm indebtedness
Cancellation of qualified real property business indebtedness
Generally, if the taxpayer excludes canceled debt from income under one of the exclusions listed
above, he must also reduce his tax attributes (certain credits, losses, and basis of assets) by the
amount excluded. He must file Form 982 (PDF), Reduction of Tax Attributed Due to Discharge of
Indebtedness (and Section 1082 Basis Adjustment), to report the exclusion and the corresponding
reduction of certain tax attributes.
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