January 18, 2023
Debtors typically experience a feeling of relief when a creditor agrees to forgive their debt. But that feeling often is replaced by shock and confusion when they learn they owe taxes on so-called “cancellation of debt” (COD) income. Read on to learn the tax rules for COD income and how they might affect your tax situation.
The IRS considers your debt canceled if it’s forgiven or discharged for less than the full amount you owe. Debt cancellation can occur in a number of circumstances. For example, it’s considered cancellation if a creditor gives up on collecting a debt you’re obligated to pay. Cancellation also occurs when there’s a foreclosure, repossession, voluntary transfer of property to the lender, abandonment of the property or a mortgage modification.
The debt you don’t end up on the hook for is treated as income for tax purposes. You generally must report it on your personal tax return. If it’s a business debt, you should report it on the applicable tax schedule. The creditor may send you a Form 1099-C, “Cancellation of Debt,” but you must report the canceled amount on your tax return for the year the cancellation occurred regardless of whether you receive such a form.
Recourse vs. Nonrecourse Debt
If your debt was secured by property and the creditor takes the property in full or partial satisfaction of your debt, the IRS treats the transaction as a sale of the property to the creditor. The resulting tax treatment will turn on whether the debt was recourse or nonrecourse.
Debt for which you’re personally liable is recourse debt. If you default and the surrender of the property doesn’t fully satisfy the debt, the creditor can go after you for the balance. You’re not personally liable for nonrecourse debt, though, so the lender is entitled only to the property if you default. If you receive a Form 1099-C from a creditor, it should indicate if you were personally liable for the debt.
With a recourse debt, the amount realized on the “sale” is the fair market value (FMV) of the property you surrender. Your taxable ordinary income from the cancellation is the amount by which the debt exceeds the FMV (assuming none of the exceptions or exclusions below applies). The difference between the FMV and your adjusted tax basis (usually your cost) will be gain or loss on the disposition of the property.
How It Works
For example, suppose you bought a vehicle for business use for $20,000, making a $2,000 down payment and signing a recourse note for the balance. You pay down an additional $4,000 on the debt before you’re unable to make any more payments, leaving outstanding debt of $14,000 ($20,000 minus $2,000 down payment minus $4,000 debt payments). The dealer repossesses the vehicle, whose FMV has dropped to $11,000, and cancels the remaining $3,000 of debt ($14,000 minus $11,000). The $3,000 is COD income. You’ll also have a $9,000 loss ($11,000 FMV minus $20,000 basis).
With nonrecourse debt, you realize the entire amount of the debt plus the amount of cash and the FMV of any property you received. You don’t have any ordinary income from the cancellation, though. In the example above, if the note was nonrecourse, you’d have a loss of $6,000 upon repossession ($14,000 realized on the remaining debt minus $20,000 basis).
Exceptions and Exclusions
The following amounts aren’t treated as COD income:
- Amounts canceled as gifts, bequests, devises or inheritances,
- Certain qualified student loans canceled due to meeting work requirements,
- Certain student loan repayment assistance programs,
- Certain student loan discharges after December 31, 2020, and before January 1, 2026,
- Amounts of canceled debt that would be tax-deductible if you, as a cash-basis taxpayer, paid it,
- A qualified purchase price reduction given by the seller of property to you as the buyer, and
- Any amounts discharged from certain federal, private or educational student loans.
By contrast, the following amounts constitute COD income — but are excluded from gross income for tax purposes:
- Debt canceled in a federal bankruptcy,
- Debt canceled to the extent you were insolvent at the time of cancellation,
- Canceled qualified farm debt,
- Canceled qualified real property business debt, and
- Canceled qualified principal residence debt that’s discharged subject to an arrangement entered into and evidenced in writing before January 1, 2026 (up to $750,000, or $375,000 if married filing separately).
The exclusions aren’t as straightforward from a tax perspective as they might seem. If you excluded canceled debt, you generally must reduce certain tax attributes (including certain credits and carryovers, losses and carryovers, and basis) by the amount excluded. The qualified principal residence debt exclusion, however, requires only the reduction of your basis in the residence.
It’s wise to consult with your CPA before you enter any debt forgiveness or relief arrangements, or reach out to us at the contact info below. Understanding the tax implications in the context of your overall circumstances can reduce the odds of an unwelcome surprise.
Jessica Kirkpatrick, CPA
Senior Manager, Tax
Yong Im G. Nam, CPA
Senior Manager, Tax