Canceled Debt: Taxable or Not

During the pandemic many clients’ businesses have adversely impacted by lockdowns and many negotiations between borrowers and lenders have occurred or will occur in 2021. There will be many loan modifications, bankruptcies, and foreclosures. In order to properly analyze the tax consequences, advisors should be well versed in Section 108, exclusions to cancellation of debt income.

In general, if a lender forgives a taxpayer’s debt, generally, that forgiveness creates taxable “cancellation of debt” (COD) income under Section 61(a)(11). You must report any taxable amount of a canceled debt as ordinary income from the cancellation of debt on Form 1040, U.S. Individual Income Tax Return as “other income” if the debt is a nonbusiness debt, or on an applicable schedule if the debt is a business debt.

After a debt is canceled, the creditor may send a Form 1099-C, Cancellation of Debt showing the amount of cancellation of debt and the date of cancellation, among other things. If you received a Form 1099-C showing incorrect information, contact the creditor to make corrections. For example, if the creditor is continuing to try to collect the debt after sending  Form 1099-C, the creditor may not have canceled the debt and, as a result, there may not be income from a canceled debt.

Amounts that meet the requirements for any of the following exclusions are not included in income, even though they are cancellation of debt income.

Exclusions from COD Income:

  1. Debt canceled in a Title 11 bankruptcy case (Section 108(a)(1)(A), which provides that no COD income arises if the debt is forgiven as part of a chapter 11 bankruptcy)
  2. Debt canceled to the extent insolvent (Section 108(a)(1)(B), which excludes COD income to the extent the borrower is “insolvent”, meaning the liabilities exceed the FMV of the borrower’s assets)
  3. Cancellation of qualified farm indebtedness
  4. Cancellation of qualified real property business indebtedness
  5. Cancellation of qualified principal residence indebtedness that is discharged subject to an arrangement that is entered into and evidenced in writing before January 1, 2021 (Section 108(a)(1)(E), which allows an individual to exclude COD income upon the forgiveness of a mortgage on the taxpayer’s principal residence)

Generally, if you exclude canceled debt from income under one of the exclusions listed above, you must reduce certain tax attributes (certain credits and carryovers, losses and carryovers, basis of assets, etc.) (but not below zero) by the amount excluded. You must attach to your tax return a Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to report the amount qualifying for exclusion and any corresponding reduction of those tax attributes. For cancellation of qualified principal residence indebtedness that you exclude from income, you must only reduce your basis in your principal residence.