Taxes and Debt Cancellation
Important information about the taxability of cancelled debt
By Dr. John L. Stancil
Tax Analyst, WebTaxCenter.com
In the recent past, a number of people have found themselves in difficult financial situations. Perhaps it came from the loss of a job, illness, or some other catastrophic event. Maybe the decline in housing prices caused a financial crisis. Many times this has led to the individual being unable to pay his or her credit card bills, car loan, or home mortgage. As a result, the debt is cancelled, reduced, or the property repossessed.
Most people do not realize it, but when this occurs, they may have taxable income when a debt is cancelled. If there is a cancelled debt, the lender should send you a 1099-C indicating the amount of debt cancellation. This cancelled debt can be taxable income. If you have property that the lender takes back, you will receive a 1099-A. This article discusses the tax impact of these documents and how to report them on your taxes. However, there are exceptions in which a debt cancellation is not taxable income. These exceptions will be discussed first.
When Cancellation of Debt Is Not Taxable
There are several exceptions that make debt cancellation not be taxable income. The most common of these include:
- If the cancellation is intended as a gift. Normally, a cancellation from a bank or other lending institution cannot be considered a gift. A gift cancellation usually arises between family members and friends.
- If the debt is forgiven as a part of a Chapter 11 bankruptcy proceeding. Note that this does not apply to Chapter 7 bankruptcy.
- If the debtor is insolvent when then cancellation occurs, the cancelled debt is not taxable to the extent of the insolvency. For example, if you have assets of $25,000 and debts of $30,000 you are insolvent by $5,000. Any debt cancellation up to $5,000 would not be taxable.
- If the debt is“qualified farm indebtedness.”
- If the discharge of a student loan occurs as a part of an agreement that the student work for a certain period of time in a certain profession.
- If the discharge is granted to a qualified victim of a terrorist attack.
- If the cancellation of debt occurs between the seller and purchaser of the property and the parties agree that the reduction in debt is an adjustment to the purchase price.
Cancellation of Unsecured Debt
Unsecured debt is debt in which no assets are given as security for the loan. For example, credit card debt is unsecured debt. If the lender cancels or reduces your debt, you should receive a 1099-C. The amount shown in box 2 of this document is taxable income to you, and is reported as “Other Income” on line 21 of the 1040, unless an exception applies.
You owe a credit card bill of $10,000 and negotiate a reduction to $4,000 in full payment of the bill. You have $6,000 in debt cancellation income.
Acquisition or Abandonment of Secured Property
When you default on your car or home loan the lender may repossess the car or house. In this case you should receive a 1099-A. This document contains several important pieces of information. It the property is repossessed by the lender it is considered an acquisition. If you leave the property, it is abandoned. In either case, this is treated as a sale of the asset.
Box 5 of the 1099-A asks if the borrower is personally liable for repayment of the debt. If this is marked “Yes,” you are liable for the full amount of the cancelled debt. This is known as a recourse loan. Most car loans and home equity lines of credit are of this nature. Many times a refinanced mortgage is a recourse loan. You will include as income excess of debt forgiveness over the fair market value of the asset. This is reported on line 21 of the 1040 under “Other Income.”
If Box 5 is marked “No,” you are not liable for the repayment of the debt. This is known as non-recourse debt. Most home mortgages are non-recourse debt if they are the first mortgage. You will not be taxed on the cancellation of the debt.
You owe $25,000 on a recourse car loan. The fair market value of the car is $20,000. The car is repossessed by the lender and the remaining debt is cancelled. You have $5,000 in debt cancellation income.
You owe $15,000 on a recourse car loan. The fair market value of the car is $15,000. You have no debt cancellation income and a $5,000 non-deductible loss on the repossession.
Reporting the “Sale” of Your Home
If an asset is repossessed or abandoned, it is treated as a sale. This may give rise to a taxable ordinary gain as well as a taxable capital gain. Losses on repossession and abandonment are not deductible for personal-use assets.
Ordinary income arises in a non-recourse loan when your cost of the asset is less than what you owe and the asset is repossessed. Capital gains arise if the fair market value of the asset is greater than the amount of debt cancellation.
If you have lived in and owned the house as your main home for 24 of the past 60 months, you will be allowed to exclude up to $250,000 ($500,000 married filing jointly) of capital gain on the sale.
You purchased your home for $150,000 and now owe $160,000 on the non-recourse loan. The fair market value of the home is $155,000. If the home is repossessed and the debt forgiven, you have $10,000 in debt cancellation income, reported as other income. Also, you have a non-deductible loss on the sale.
You purchased your home for $150,000 and owe $120,000 on a non-recourse loan. The bank repossesses the house when the fair market value is $175,000. The difference between your purchase price and the fair market value is a $25,000 capital gain. However, if you qualify for exclusion as discussed above, there are no tax consequences – this sale does not get reported on your return.
This article has focused on debt cancellation for personal-use assets. The rules for business assets are somewhat different and this discussion does not apply to them. For more information about this topic, you can consult your tax professional or visit www.webtaxcenter.com
. IRS Publications 523, 544, and 908 also have information regarding this subject.
Dr. John L. Stancil, a tax analyst for WebTaxCenter.com, has been a member of the Florida Southern College faculty since 1998. He received his bachelors degree from Mars Hill College and holds a M.B.A. from the University of Georgia. He later earned his doctorate in accounting from the University of Memphis. He holds four professional certifications, including CPA, CMA, CFM and CIA. Stancil has received the Florida Institute of CPAs 2005 Outstanding CPA in Public Service Award. (This award is given annually to a Florida CPA who has demonstrated significant contributions through community and civic activities.) He has also been recognized as the Expert of the Month on several occasions by allexperts.com.