It is not uncommon for debts to pile up beyond someone’s ability to pay, and may be even more common if we enter into a recession.
Lenders will sometimes cancel (forgive) debts owed by down-on-their-luck borrowers.
While the cancelled debt may be incredibly helpful in the short run, there can be negative consequences from a tax perspective.
That’s because, generally, COD income is taxable.
When a lender forgives debt, the IRS views that forgiven debt as income. Their thinking is thus: if you owe $10,000 and that debt is forgiven, that is similar to someone giving you $10,000 and all worldwide income is taxable unless specifically exempted in the tax code.
But there are exceptions in Section 108 of the tax code. We’ll talk about the most common exceptions we have seen over the years below.
First you should be aware that lenders report COD income to both the borrowers that had the debt forgiven and the IRS. This is reported on a 1099-C (Cancellation of Debt) for the year the debt cancellation occurs. The form shows the amount of debt cancelled, unpaid interest included in the debt (reported separately on the form), and the date the debt was cancelled. If you receive one of these forms, don’t ignore it.
If you can’t use one of the debt cancellation methods that are allowed, the income has to be reported on your tax return and will obviously result in higher taxes for the year the debt was forgiven. The more debt forgiven, the higher the tax bill. This can be nearly as problematic as the original debt.
So, here are very simple descriptions of 3 common allowable exceptions for COD Income. Each case is unique and you should seek professional advice if you think you are qualified.
The first is bankruptcy. I am not a bankruptcy attorney but I have seen a number of these cases where we’ve been able to use this exception to reduce or eliminate taxable COD income. This generally applies to the debt discharged within the bankruptcy proceeding. Cancelled debt outside the bankruptcy is treated as taxable income and may or may not be exempt from taxation in a way other than the bankruptcy exemption.
The second is insolvency. I’ve seen this used more often than bankruptcy to except COD income. If your liabilities exceed the fair market value of your assets on the day of the debt cancellation, your debt can be cancelled to the extent of the insolvency. For example, you have $20,000 in debt forgiven and your liabilities were $10,000 greater than your assets on the day of the debt cancellation (as seen on the 1099-C), then you can exempt $10,000 of the forgiven debt from taxation.
There is a process to determining the amount of insolvency that has to be followed. It’s time consuming but not especially difficult. The last process used is called the principal residence mortgage debt exception. Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income – or $375,000 if the borrower files separately – from the cancellation of qualified principal residence indebtedness. This is defined as debt that was used too acquire, build, or improve the borrower’s principal residence and is secured by that
was forgiven. The more debt forgiven, the higher the tax bill. This can be nearly as problematic as the original debt.
So, here are very simple descriptions of 3 common allowable exceptions for COD Income. Each case is unique and you should seek professional advice if you think you are qualified.
The first is bankruptcy. I am not a bankruptcy attorney but I have seen a number of these cases where we’ve been able to use this exception to reduce or eliminate taxable COD income. This generally applies to the debt discharged within the bankruptcy proceeding. Cancelled debt outside the bankruptcy is treated as taxable income and may or may not be exempt from taxation in a way other than the bankruptcy exemption.
The second is insolvency. I’ve seen this used more often than bankruptcy to except COD income. If your liabilities exceed the fair market value of your assets on the day of the debt cancellation, your debt can be cancelled to the extent of the insolvency. For example, you have $20,000 in debt forgiven and your liabilities were $10,000 greater than your assets on the day of the debt cancellation (as seen on the 1099-C), then you can exempt $10,000 of the forgiven debt from taxation.
There is a process to determining the amount of insolvency that has to be followed. It’s time consuming but not especially difficult.
The last process used is called the principal residence mortgage debt exception. Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income – or $375,000 if the borrower files separately – from the cancellation of qualified principal residence indebtedness. This is defined as debt that was used too acquire, build, or improve the borrower’s principal residence and is secured by that residence.
Refinanced debt can qualify to the extent that it replaces debt that was used to acquire, build, or improve the borrower’s principal residence.
The process isn’t entirely pain-free and there are special rules for partnerships, LLC’s treated as partnerships and S Corporations. You definitely need to seek professional help if you think one of these methods may be helpful in your circumstances.
For more information, see https://www.irs.gov/forms-pubs/about-publication-4681, or https://www.irs.gov/pub/irs-pdf/p908.pdf.
We hope you find this information useful.
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