Cancellation of Debt

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What is Cancellation of Debt?

Cancellation of debt (COD) refers to full or partial debt relaxation provided by the creditors to debtors. It relieves the borrower from paying any outstanding amount due to the lender. It happens when the creditor is unable to recover the dues or the borrower bargains to reduce the debt obligation.

Cancellation of Debt

Debt cancellation usually results from loan forgiveness, negotiation with creditors, debt relief schemes, or filing bankruptcy. In the event of such cancellation, the debtor is liable to pay tax on the amount of debt forgiven. However, IRS (Internal Revenue Service) allows some exceptions and exclusions to the rule. Creditors must report the canceled debt to the debtor on a 1099-C Form.

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  • Cancellation of debt (COD) occurs when the moneylender relieves the borrower from the debt obligation, partially or completely.
  • Borrowers may seek debt relief through negotiations with lenders, foreclosure, debt relief programs, or bankruptcy. 
  • Legally, COD relieves the debtor of the debt obligation but requires reporting the forgiven debt as taxable income while filing tax returns (Form 1040). However, the IRS lays down certain exceptions to filing requirements. 
  • A lender who has canceled a debt of $600 or more must file Form 1099-C for each such borrower.

Cancellation of Debt Explained

Debtors are lawfully obliged to repay any amount borrowed from lenders within the agreed time period. However, if due to unforeseen circumstances, the borrower is unable to return any amount of the debt, and the creditor agrees to write it off as bad debts. In that case, such a sum of money is referred to as canceled debt.

Note that either borrower or moneylender can initiate debt cancellation. Any type of debt like real estate, credit card overdue, student loans, medical bills, or IRS debt can qualify for debt cancellation.

Forgiveness of real estate debt occurs due to reclamation, foreclosure, discretionary land surrender to the mortgagee, contract alteration, or property withdrawal. Eligible candidates can seek partial or full student loan forgiveness. In addition, credit card companies may choose to forgo some amount of outstanding debt for immediate partial settlement.

Usually, borrowers negotiate with lenders themselves or take the help of debt relief companies to reach mutually agreeable debt settlement terms. In other cases, they resort to filing for bankruptcy.

The IRS considers canceled debt as taxable income and requires the borrower to pay taxes on the discharged debt. Therefore, debt cancellation provides relief to the debtor only from debt, not tax liability.

Exceptions to Cancellation of Debt

Exceptions

According to IRS, a canceled debt must be reported as income. However, it offers certain exceptions to the rule.  The following amounts are not considered to be cancellation of debt income:

  1. Debt is canceled as a gift, inheritance, devise, or bequest.
  2. Student loan canceled due to meeting specific work requirements.
  3. Certain student loans discharged after December 31, 2020 and before January 1, 2026.
  4. Amount discharged under assistance programs for student loan repayment.
  5. Canceled debt that would be deductible only when paid by the cash basis taxpayer. 
  6. A qualified discount on the purchase price offered by the property seller to its buyer.
  7. Cancellation of debt from certain private, educational, or federal student loans.

Exclusions

The IRS excludes the following canceled debt from being reported as income:

  1. COD to the extent insolvent
  2. COD in a Title 11 bankruptcy case
  3. Qualified real estate business obligation canceled
  4. Qualified farm liability canceled
  5. Qualified main residence indebtedness canceled

While excluding canceled debt from income, debtors must reduce specific tax features by the sum excluded. This includes losses and carryovers, certain credits and carryovers, the basis of assets, etc. To cancel qualified main residence indebtedness, debtors must only decrease their basis in residence. 

A Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), must be attached to the tax return. This lets debtors report the qualified amount for exclusion with any relative reduction of tax features. 

Is Canceled Debt Taxable?

Canceled debt attracts tax on it. Thus, the debtor must report the debt discharged as income in their tax returns in the cancellation year. Failure to do so may result in penalties imposed by the IRS.

When creditors agree to forgo any sum due and cancel the same, they are responsible for sending a 1099-C Cancellation of debt form to the debtor to acknowledge the cancellation. However, irrespective of the receipt of Form 1099-C, the debtor is obliged to file returns.

Debtors must usually report the canceled debt as ordinary income from debt forgiveness on the below-mentioned forms. If it is a business debt, report on an applicable schedule. However, record it as other income if it is non-business debt.

  1. Form 1040, US Individual Income Tax Return
  2. Form 1040-SR, US Tax Return for Seniors
  3. Form 1040-NR,  US Non-resident Alien Income Tax Return 

Example

Suppose A borrows $10,000 from B, promising to return by the end of 2021. A repays $2000, but he is unlikely to pay any further due to a severe financial crunch. So he approaches B and requests him to forgo $3000 of his debt in a settlement of $5000 to him immediately.

B agrees to the condition, receives $5000, and cancels the remaining $3000 ($10,000 - $5000 -$2000). B reports $3000 canceled debt on Form 1099-C. B sends the form to A by January 31, 2022. Therefore, he must report $3000 as taxable income on his tax returns for the year 2022. However, this rule has several exceptions and exclusions, as discussed above.

Debt Secured by Property/Asset

If the creditor confiscates the debt-securing asset for discharging a full or partial liability, it is inferred as property sold to the creditor. Therefore, the reporting of the canceled debt as ordinary income for taxation depends on whether the debt was recourse or non-recourse. 

Recourse Debt

Ordinary income from COD is the outstanding debt in excess of the asset's fair market value (FMV). The difference between FMV and the adjusted basis (cost, in general) will be the profit or loss on the asset's disposal. 

Non-recourse Debt

In this case, there is no ordinary income from COD. The difference between the outstanding debt and the asset's cost will be the profit or loss on its disposal. 

Frequently Ask Questions (FAQs)

Q#1 – Is cancellation of debt a good or bad concept?

A – Debt cancellation is typically a good concept for debtors in bad shape. It does not adversely affect the credit score and releases the borrower from the debt obligation. However, they must report it as an ordinary income on the tax return statement.

Q#2 – Why would the creditor settle for cancellation of debt?

A – The creditors may settle for debt cancellation if it remains unpaid for a long time. They may partially relax the debt in return for immediate payment of the remaining amount. In doing so, they must send Form 1099-C to the debtor and mark the debt off their book.

Q#3 – What does the 1099-C cancellation of debt imply?

A – The IRS specifies that almost any canceled, discharged, or forgiven debt becomes an ordinary taxable income for the debtor. Hence, debtors receive Form 1099-C Cancellation of Debt from the creditor to mention the same. The form mentions the canceled amount, the date of cancellation, etc.