Canceled Debt - Is it Taxable or Not?

In general, if you are liable for a debt that is canceled, forgiven, or discharged, you must include the canceled amount in gross income unless you meet an exclusion or exception. However, canceled or forgiven debt is not considered income if it is intended as a gift or bequest.

A debt includes any indebtedness for which you are personally liable or for which you are liable only to the extent of the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, a repossession, a voluntary return of the property to the lender, abandonment of the property, or a principal residence loan modification. You must report any taxable amount of a debt that is canceled, as ordinary income from the cancellation of debt, on Form 1040 or Form 1040NR and associated sub-schedules, as advised in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals).

Caution: If your debt is secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have a reportable gain or loss. The gain or loss on such a deemed sale of your property is a separate issue from whether any canceled debt also associated with that same property is includable in gross income. See IRS Publication 544, Sales and Other Dispositions of Assets, for detailed information on reporting gain or loss from repossession, foreclosure or abandonment of property.

If a federal government agency or an applicable financial entity cancels or forgives a debt you owe of $600 or more, you should receive a Form 1099-C (PDF), Cancellation of Debt, showing amounts and other information relating to the cancellation. The amount of canceled debt is shown in Box 2 of the form. Taxpayers may also receive a Form 1099-A (PDF), Acquisition or Abandonment of Secured Property.

Canceled Debts that meet the requirements for any of the following exceptions or exclusions are not taxable.

Canceled Debt that Qualifies for Exception to Inclusion in Gross Income:

   1. Amounts specifically excluded from income by law such as gifts or bequests
   2. Cancellation of certain qualified student loans
   3. Canceled debt that if paid by a cash basis taxpayer is otherwise deductible
   4. A qualified purchase price reduction given by a seller

Canceled Debt that Qualifies for Exclusion from Gross Income:

   1. Cancellation of qualified principal residence indebtedness
   2. Debt canceled in a Title 11 bankruptcy case
   3. Debt canceled due to insolvency
   4. Cancellation of qualified farm indebtedness
   5. Cancellation of qualified real property business indebtedness

The exclusion for "qualified principal residence indebtedness," provides canceled debt tax relief for many American home owners involved in the mortgage foreclosure crisis currently affecting much of the country. The exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of "qualified principal residence indebtedness".
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