Is cancellation of debt always taxable?
In general, the term income as used in the Internal Revenue Code includes income from any source, including any accession to the taxpayer’s wealth. It follows then that a taxpayer who has incurred canceled debt generally has realized an accession to wealth.
So, is debt cancellation or forgiveness taxable? Not always. Here are some exceptions-
Principal Residence: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners. It expires at the end of 2012. If you receive a 1099-C (Cancellation of Debt) from a lender for the 2013 tax year, you might have to include the amount in your taxable income.
Student Loans: Student loan cancellation will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation. To use this provision the loan must have originated from one of the following-
- the federal government, or a state or local government or subdivision;
- a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or
- a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.
You can also exclude the cancelled debt if you are bankrupt or insolvent (see below).
Credit Card Debt: Similar to student loans, only two scenarios allow you to exclude credit card debt- bankruptcy and insolvency (see below).
Disputed Debt: According to common law if the discharged debt comes from a contested liability then the canceled debt is not considered income. Of course the dispute must be in good faith. Simply misunderstanding the financing terms is not a good faith dispute.
Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets. This is the ace in the hole so-to-speak when it comes to keeping cancelled debt out of your taxable income. Keep in mind however that your assets include retirement accounts even though you might not have unfettered access to them.
You can download the IRS Insolvency Worksheet at wcginc.com/InsolvencyWorksheet.pdf.
Non-Recourse Loans: A non-recourse loan is a loan for which the lender’s only remedy during default is to repossess the property being financed or used as collateral. In other words, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. There might be other tax consequences with non-recourse loan forgiveness. Also, non-recourse loans are super rare on mortgage loans (although they are becoming more prevalent with IRA / 401k purchases of property).
These exceptions are discussed in detail in IRS Publication 4681.