When a debt is cancelled, the debtor is no longer liable for the funds borrowed or the items purchased with the money. If an obligation to repay no longer exists, the Internal Revenue Service (IRS) typically considers the cancellation as a type of income for the debtor, although there are certain exceptions to this rule.
Bankruptcy and Insolvency
Taxpayers in certain situations may avoid paying taxes on debt cancellations. If your debt was forgiven as part of a bankruptcy proceeding, it is not taxable. For taxpayers with a debt cancelled during a period of insolvency, a portion or the entire amount of the cancelled debt may avoid taxation. The IRS recommends consulting with a tax attorney to determine whether you are truly insolvent. Otherwise you may file your income tax return improperly and incur penalties and interest on taxes owed.
Debt Excluded from Income
Some cancelled debts do not count toward the taxpayer's total income with the IRS, which prevents the forgiven amounts from being taxed. The IRS allows gross income exclusions for gifts and bequests that the law excludes from income. The IRS also excludes the cancellation of qualifying student loan debts, seller price reductions on an eligible purchase, and cancellations of debt that a taxpayer using the cash basis would ordinarily deduct.
When a home is foreclosed and the debt is cancelled, the amount of the debt cancelled is taxable. For example, if you obtained a mortgage for $120,000 and paid $90,000 toward the mortgage prior to foreclosure and the cancellation of your debt, the debt forgiven equals $30,000 and becomes taxable income. An exception to this rule is granted for non-recourse loans. The Mortgage Forgiveness Debt Relief Act of 2007 also allows taxpayers from 2007 to 2012 to avoid counting the debt cancellation as income when the foreclosed property is a primary residence.
IRS Form 1099-A
Debt cancellation requires the lender to file tax forms with the IRS. Forms 1099-A, Acquisition or Abandonment of Secured Property, and 1099-C, Cancellation of Debt, are both used to cancel debt. In some instances, both forms must be filed for the same debt cancellation, while certain situations require only one form. The IRS Instructions for each form feature detailed information specifying which form to file in a certain situation.
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