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Cancellation of Debt: What Do You Mean I Have to Pay Tax on That?

Aug 30, 2023 | Tax

If you had debt that was reduced or canceled not through bankruptcy or insolvency, that reduction may be taxable. Even though there are no actual cash proceeds, cancellation or discharge of debt is counted toward your income. Under Internal Revenue Code Section 61 (a)(12), gross income includes “income from discharge of indebtedness” and must be reported on a taxpayer’s return. In addition to the principal amount you receive relief from, interest may also be considered canceled debt included as income, unless it would have been deductible.                              

What is Cancellation of Debt?

If you borrow funds and are legally obligated to repay a determinable amount, you have incurred a debt. Cancellation of debt occurs when a borrower is released from the obligation to repay the funds, and the creditor either cannot collect or gives up collecting on the debt. Cancellation of indebtedness income can arise due to specific actions taken by the creditor, such as a formal discharge, or by operation of law. 

Cancellation of debt may also occur due to:

  • Bankruptcy
  • Foreclosure
  • Repossession
  • Voluntary property transfer
  • Abandonment of the property
  • Mortgage modification 

Generally, if your debt was canceled, discharged, or forgiven for less than the obligation, the amount of canceled debt is taxable and must be reported for the tax year the cancellation occurred. When debt has been canceled, the creditor may issue a Form 1099-C that shows the amount of debt that has been canceled and other information. If the form is incorrect, the creditor should be contacted to cure any mistakes. For example, if the creditor continues to attempt to collect the debt, that debt may not actually be canceled — and should not count as income. A taxpayer must report their canceled debt to the Internal Revenue Service (IRS), regardless of whether the creditor has sent a Form 1099-C.  

Exceptions to Cancellation of Debt from Income and Exclusions from Gross Income

Certain exceptions to cancellation of debt income exist under tax law. These exceptions include any amount canceled as an inheritance, amounts discharged from certain student loans, and canceled debt that would otherwise be deductible if it were paid. Amounts that meet these requirements are not considered cancellation of debt income. 

The IRS excludes certain types of debt from counting toward gross income, even though they are cancellation of debt income. Debt canceled in a Chapter 11 bankruptcy, cancellation of qualified farm indebtedness, cancellation of qualified real property business indebtedness, and debt canceled to the extent of insolvency are not considered as part of a taxpayer’s gross income. Cancellation of qualified principal residence indebtedness that was discharged subject to an arrangement made in writing before January 1, 2026 is also excluded. 

Taxpayers who exclude canceled debt from their gross income must reduce certain credits and carryovers by the excluded amount. A Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness and Section 1082 Basis Adjustment should be submitted to the IRS along with the tax return for the year to report the amount that qualifies for the gross income exclusion. If cancellation of qualified principal residence indebtedness is excluded from income, only the basis in the principal residence must be reduced.      

Contact an Experienced New York Tax Attorney

If you are facing a tax matter, it’s essential to have the counsel of an experienced tax attorney who can advise you and help you achieve the best possible outcome in your case. Offering reliable legal services and skillful representation the legal team at Brinen & Associates assists clients with a broad scope of tax matters at both the state and federal levels. Call (212) 330-8151 or send us a message to learn more about how we can help you and your business.


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