Tax Implications of Cancelled Debt Income (Form 1099-C or 1099-A)

If you have cancelled debt associated with real property (such as a home), intangible property (goodwill, patents), or tangible property (such as a car),  then you may receive a Form 1099-C from the creditor, which is simultaneously submitted to the IRS.   The Internal Revenue Code states that the discharge of indebtedness must be counted as taxable income. However, there are certain exceptions that can exclude cancelled debt as income.  If applicable, the cancelled debt income needs to be recognized on the return and the exception must be elected.

The three most common exceptions include: 1) Insolvency 2) Qualified Mortgage Indebtedness and 3) Bankruptcy.

Insolvency –  Cancelled Debt can be excluded to the extent of insolvency.  For example, a taxpayer’s loan of approximately $50,000 is cancelled.  The taxpayer has assets of about $100,000 and debt including the loan of about $125,000.  The taxpayer is insolvent to the extent of $25,000 and therefore, $25,000 of the cancelled debt will be exempted from taxable income and $25,000 will be deemed taxable.

Qualified Mortgage Indebtedness – This exception was created by the Mortgage Debt Relief Act of 2007.  This provision excludes principal residence debt up to $2 million ($1 million for Married Filing Separately) for debt discharged during tax years 2007 through 2013.  It is uncertain whether this will be renewed for 2014 and forward.   Therefore, if a taxpayer receives a 1099-C on the deficiency associated with their principal residence due to a short sale, deed in lieu of foreclosure, abandonment of property, foreclosure, etc, the taxpayer can exclude this deficiency up to $2 million if this was the taxpayer’s principal residence. Cancelled debt income on a second home would not be eligible to be exempted under this provision.

Bankruptcy – If a discharge of indebtedness occurs in a Title 11 case, then this should be not included as taxable cancelled debt income.

A taxpayer may be eligible for one of the above exceptions to exclude cancelled debt from taxable income.

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