By Jason Watson (Google+)
If you borrow money from a commercial lender and the loan is later canceled or forgiven, you may have to include the cancelled amount in your taxable income. When you borrowed the money you were not required to include the loan proceeds in your income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds may be reportable as taxable income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
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.
Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
So is it debt cancellation considered income?
Perhaps. If a debt is canceled or forgiven other than as a gift or bequest, the taxpayer must include the canceled debt in his or her income. If an outstanding loan is discharged in bankruptcy or canceled due to a taxpayer’s insolvency, then it is not included in the taxpayer’s income.
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.
Also, the current amnesty program for taxpayers who had a short-sale or a foreclosure ends in 2012. Starting in 2013, you can still exclude the debt forgiveness associated with your primary residence if you are insolvent. To be insolvent your total debt including the debt forgiven must exceed your assets. In other words, could you have sold everything you owned and cashed in all your retirement accounts, and still not pay off all your debts?
Download the Insolvency Worksheet here. WCG (formerly Watson CPA Group) is well versed with insolvency and debt forgiveness issues, and we can guide you through the necessary steps to minimize the tax consequence.
There are several other exceptions, see Is cancellation of debt always taxable?