What is cancellation of debt income?

The Internal Revenue Code defines gross income as all income from whatever source derived.  Discharge of indebtedness income is included in gross income.  Discharge of indebtedness income arises when a debt is canceled or forgiven, or if a creditor accepts less than the full amount of the unpaid balance on a debt as payment in full of the obligation.  The amount of gross income is the difference between the amount of the debt being canceled and the amount paid to settle the debt.

What is a debt?

One must have a true debt to have income from the cancellation of indebtedness. A true debt exists when there is an unconditional and legally enforceable obligation to repay a loan.

Not all transfers of money are true debt and therefore do not result in gross income if the debt is forgiven. For instance, if a parent loans money to a child with a schedule of payments and interest but thereafter refuses payment, it is possible that the cancellation of any duty to repay may qualify as a gift under applicable tax laws.  In a business context, the question of whether a transfer of money or property is debt or equity will dictate whether failure to fully repay the transferor will create cancellation of indebtedness income.

How to calculate cancellation of debt income.

The amount of cancellation of indebtedness income is generally the difference between the amount of debt being canceled minus the amount paid to settle the debt.

Relief from cancellation of debt income.

The Mortgage Forgiveness of Debt Relief Act of 2007 may allow homeowners to exclude forgiven debt income if it is due to a discharge of debt secured by a primary residence. Income derived from restructuring a mortgage and debt forgiven in the restructuring is included. This law applies the debt forgiven between 2007 and 2012 on amounts up to $2 million. To qualify, the money derived from the debt must have been used to buy, build or substantially improve a principal residence. Funds used to refinance a home may also qualify.

The American Recovery and Reinvestment Act of 2009 provides additional relief for taxpayers facing cancellation of debt income. The new law allows taxpayers to elect to defer cancellation of indebtedness income earned between January 1, 2009 and December 31, 2010.  Instead of being recognized in the year of the cancellation of debt, this law permits a taxpayer to spread the income, and the tax burden from that income, over a five year period.

The exclusions also include provisions relating to debts discharged during bankruptcy and debts of taxpayers who are insolvent prior to the cancellation of debt.

If a taxpayer qualifies for an exclusion of debt forgiven, he or she must file an IRS Form 982 in addition to the 1099-C issued by the creditor upon a forgiveness of debt for less than full value.

The bottom line.

Be aware of and prepare for cancellation of indebtedness income when negotiating forgiveness of debt with creditors. Knowing the amount of income that will be reported to the IRS will help you plan ahead and prevent an unexpected tax bite next year.