What is Cancellation of Debt?

Debt in layman’s term is understood as a liability incurred by a person with an obligation to pay the certain sum. However, when a debt has been cancelled or your creditor forgives without requiring any consideration in return is an act of generosity.

Cancellation of Debt has different meaning and effect for the present law. For instance, you borrow money, the borrowed amount does not incur taxes but you are bound to pay the amount. Subsequently, the lender told you not to pay the debt and you are freed from the obligation. Since you received money for free, the law viewed it as an income. Thus, all income is taxable. Cancellation-of-debt is considered as income to the debtor which must be included in a taxpayer’s income and in most cases, it is taxable as ordinary income. You might consider it unfair after negotiating away debt, it comes back and haunts you as taxable income.

Exclusions to the Rule

In the United States, when debt is canceled it has tax consequences. In a case decided by US Supreme Court, “Income is defined as an accession of wealth that is clearly realized and over which the taxpayer has complete dominion.” A canceled debt is a freed asset that can be on anything at taxpayers’ discretion. However, there are exceptions to the rule:

• When debts are canceled as a gift, devise or inheritance
• Cancellations of student loan for working for a certain employer
• When indebtedness was canceled due to taxpayer’s insolvency. Insolvency occurs you’re your total liabilities are more than the value of your assets. It will also take place in a bankruptcy case and it takes precedence over insolvency. If such the facts, the debtor must be under the jurisdiction of the court and the cancellation must be granted by the court or occurs as a result of a plan approved by the court. Accountants and bookkeepers must see to it to include such circumstance for the benefit of the business owners.
• Cancellation of qualified farm indebtedness if the debt incurred in connection with taxpayers’ trade or business and 50% or more of the aggregate receipts for 3 taxable years is attributed to the trade or business of farming.
• Cancellation of qualified real property business indebtedness if such debt incurred in relation to real property trade or business. This exclusion will only reduce the basis for depreciable real property of the taxpayer
• Cancellation of qualified principal home indebtedness. A taxpayer is permitted to exclude up to $1,000,000 for qualified principal residence indebtedness. $2,000,000 if married, and filed separately. This exclusion expired after December 31, 2016, unless discharged before January 1, 2017, or written arrangement entered into before January 1, 2017. In order to qualify for the above exceptions, some conditions must be met first:
• Taxpayers’ indebtedness must result from which the taxpayer is liable. The lender must have the capacity to enforce the liability legally, otherwise, no tax consequence exists.
• Indebtedness subject to which the taxpayer holds property. If conditions are present, the taxpayer must show evidence that he falls under one of the abovementioned exceptions.

When and How to File?

Internal Revenue Service (IRS) is a government agency under the Department of Treasury. IRS is responsible for collecting taxes and administer revenue code. For cancellation of debt use the Form 1099-C and you’ll have to report the amount to IRS as taxable income. When a creditor cancels a debt of $600 or more is mandated to file the form along with Form 1096 by January 31 of the following year on the date the debt was canceled. When the date falls on a weekend, the filing date shall be moved to the next business day.

Taxpayer’s failure to file the form on time shall be liable for civil penalties of not more than $150 per form. Tax preparers and accountants of the company must observe the requirements provided in the law to avoid penalties. Common situations where you will receive such form when there’s repossession, foreclosure, the return of property to a lender, abandonment of property or modification of a loan on your principal residence. Reduction of Tax Attributes

Tax attributes prevent the creation of new tax burden in case of insolvency, bankruptcy or any case included in the exclusions. It is a tax credit or loss that must be reduced as a result of the exclusion of debt cancellation from a taxpayer’s gross income. Reduction of tax attributes is made after the determination of the tax imposed for the taxable year. When debts are forgiven as a result of bankruptcy, must not include the debt as income but tax attributes will be reduced up to the amount of the forgiven debt.

If IRS requires the taxpayer to make a tax credit, they will use the Form 982.

Written by Tax Professionals