The IRS general rule is discharged debt is considered as taxable income. For example, credit card debt is generally treated as taxable income. But there are many exceptions where you may not pay any tax on cancellation of debt income such as:
- You filed for bankruptcy and the debt is discharge as part of bankruptcy proceedings.
- You are insolvent, which means your debts were greater than your assets when the debt was forgiven. The debt will not be taxable up to the amount of insolvency. A complicated calculation is made using includable liabilities & assets, and their estimated values, to determine how much of the cancelled debt will not be taxable under this exception.
- Your debt on real business property is forgiven, and that property is not owned by a C Corporation. For example, this exception will apply if you personally own a rental building and debt is forgiven.
- Your debt forgiven is on your qualified principal residence acquisition debt. This means the debt was incurred to acquire, construct or substantially improve your principal residence. This exception won’t include a “home equity loan” used to pay off credit card, purchase a car, pay medical bills, etc. You can exclude up to $2 million of forgiven debt. ($1 million if you are married and file a separate tax return).
It is very important to note: The debt on qualified residence acquisition debt must be discharged by December 31, 2012 to avoid taxation under this exception.
A mortgage company, credit card company and any other lender who cancels debt must issue Form 1099-C listing the amount forgiven. The IRS will consider this as taxable income unless you report why the income should be excluded. You may be able to use Form 982 to exclude the cancelled debt from taxable income if you qualify for one of the exceptions discussed above.
You must deal with the 1099-C on your tax return; don’t ignore it. Let an experienced tax professional help you minimize your taxes.
