Cancellation of Debt is Taxable Income

By Kelly M. Walsh

Many people do not realize that they can have taxable income, without receiving a penny of money, if a creditor forgives their debt. The situation may arise in a variety of situations, including when you negotiate a settlement with a creditor, when real estate is sold in a short sale or foreclosure, when debts are discharged in bankruptcy, or suddenly out of the blue when the creditor claims a tax write off after years of nonpayment.

Let’s take the first scenario as an example. Suppose you owe $10,000 to a creditor for an old credit card debt. After some negotiation, the creditor agrees to accept $6,000 to settle the account in full. In addition to paying the creditor $6,000, you will have to pay the IRS tax on the $4,000 that is forgiven as part of the bargain. The creditor is required to issue a form 1099-C, or sometimes a form 1099-A, reporting the portion of the debt that was cancelled and send a copy to the IRS. The IRS will then keep an eye on the debtor’s tax return to ensure the cancelled debt is properly reported as income on the debtor’s next income tax return.

There are a number of exceptions and exclusions to paying tax on cancellation of debt. The most common are insolvency and bankruptcy. In the case of the settlement above, it would be important for the taxpayer to keep records of the value of their assets and the total amount of their debts as of the date of the settlement. A capable tax preparer will exclude all or part of the cancellation of debt from income by showing that the taxpayer was insolvent at the time—meaning the value of the taxpayer’s assets was exceeded by the taxpayer’s total debts.

If the taxpayer files for bankruptcy, and the cancelled debt was discharged in bankruptcy, then the full amount of the cancellation of debt is excluded from income under the bankruptcy exclusion. In some instances, the tax consequences may tip the scales in favor of filing bankruptcy rather than negotiating settlements on all your debts. It also might make sense to file for bankruptcy as part of the process of negotiating a short sale on real estate, to avoid what could be a difficult tax burden arising out of the unpaid mortgage balance.

Bankruptcy offers relief to individual people who anticipate they will be assessed tax on cancellation of debt. However, the matter is much more complicated if it is a business that discharges its debts through bankruptcy. In many cases, the cancellation of debt income from the business’s bankruptcy is passed through to the individual partners or members of the business entity. If those individual partners or members did not also file a personal bankruptcy, they do not qualify for the bankruptcy exclusion to tax on cancellation of debt. That tricky situation can be avoided in some cases through careful planning, including choices in how you set up your business entity from the very beginning.

If you or your business are struggling with debt, bankruptcy, or cancellation of debt income, contact Scaringi Law. Our qualified attorneys can help you negotiate the complex interactions between tax, bankruptcy, and corporate law in this area and help you put together a strategy to protect yourself.