A lender canceling or forgiving a debt you owe can be great news. After all, you no longer have to worry about monthly payments, late fees, or accumulating interest. However, that doesn’t mean there aren’t strings attached — not to mention the possibility of an unpleasant surprise at tax time.
Canceled or forgiven debt is often taxable to the debtor as income, meaning that even though you no longer need to pay back your lender, you may still owe taxes on the canceled amount.
Nobody likes to receive an unexpected tax bill, especially when it is related to a financial obligation that no longer applies. Nevertheless, understanding what to expect can help you better prepare and take advantage of any exceptions, exemptions, or exclusions that may apply.
Read on to learn more about debt cancellation, how to report your canceled debt, and whether or not you are likely to owe income tax on the canceled amount.
Federal student loan forgiveness has been in the news lately, and many business owners may remember having their pandemic relief Paycheck Protection Program loan forgiven by the government.
There are also several other reasons your creditor may forgive your debt in part or in full. For example, a friend or family member may voluntarily forgive your debt in their will or choose not to collect. Likewise, filing for bankruptcy, utilizing business or farm exclusions, cases of death or permanent disability, or a creditor deciding to give up on collecting can all lead to a cancellation of debt (or COD) — a settlement of a debt for less than the amount owed.
Suppose you own property subject to a debt. In that case, cancellation of the debt may occur because of a foreclosure, a repossession, a voluntary transfer of the property to the lender, abandonment of the property, or a mortgage modification.
Generally, the amount of debt forgiven or canceled is still taxable to you. So, if your lender cancels your $10,000 debt, you may still owe taxes on that $10,000, which the IRS treats as gained income.
Furthermore, you may be required to report the canceled debt on your tax return for the year the cancellation occurred.
Having said that, some exceptions can apply in certain circumstances, and your canceled debt’s tax treatment may vary depending on your situation.
If you filed for bankruptcy or you were financially insolvent when your lender canceled the debt, you can reduce or eliminate your tax bill for the amount canceled. Likewise, if your debt includes tax-deductible interest, you do not need to report the interest as income since it would have been deductible regardless.
Additionally, suppose a lender takes property that is security for a debt in full or partial satisfaction of the debt. In that case, the transaction is treated as a sale of property, which may result in a gain or loss. Similarly, if the lender then cancels a debt amount over the property’s Full Market Value (FMV), the amount in excess of FMV counts as ordinary income in addition to any gain or loss from the sale. Finally, if the lender cancels the debt as a gift, the amount canceled does not count as income (although gift tax may apply).
Let’s take a more detailed look at some exceptions and exclusions…
Amounts that meet the requirements for any of the following exceptions are not considered income by the IRS:
The IRS does consider amounts that meet the requirements for any of the following exclusions to be cancelation of debt income. However, such amounts are not included in gross income:
Generally, suppose you exclude canceled debt from income under one of the above exclusions. In that case, you must reduce specific tax attributes (certain credits and carryovers, losses and carryovers, the basis of assets, etc.) (but not below zero) by the amount excluded. You must attach to your tax return a Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the amount qualifying for exclusion and any corresponding reduction of those tax attributes.
If your lender cancels or forgives a debt of $600 or more, it must provide you with a Form 1099-C, Cancelation of Debt, showing the amount of canceled debt to be reported as income, the date of cancelation, and more.
That doesn’t mean you’re off the hook. The lender may have reported the debt cancelation to the IRS themselves, which means if you neglect to report it as well, you could end up with a tax bill or even be audited. Between IRS interest and penalties, you may ultimately pay more than you would have in the first place. That’s why it’s critical to ensure you accurately report canceled debts.
Finally, if you receive a Form 1099-C showing incorrect information, you should contact the creditor to make corrections.
For example, if the creditor continues to collect the debt after sending you the form, they may still need to cancel the debt. As a result, you may not have income in the eyes of the IRS, so be sure to verify your specific situation with the creditor. Your responsibility to report the taxable amount of canceled debt as income on your tax return for the correct year remains the same whether or not you receive a correct Form 1099-C.
Should your canceled debt tax bill be overwhelming, the IRS offers short- and long-term installment payment plans (although both interest charges and penalties apply).
Lastly, if you have already paid taxes on a debt cancelation that you subsequently realize was eligible for an exclusion, you can amend your return for up to three years from the original filing date or two years from the date of payment, whichever is later.
The cancelation of debt may seem like an ideal situation on the surface level. While there are undeniable benefits to not having to pay back a lender, it is also essential to understand the tax consequences to avoid the unpleasant surprise of an unexpected bill.
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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
His business experience includes:
Creating and preparing financial reporting, budgeting and forecasting.
Planning and preparation of GAAP and other basis financial statements.
Providing insight on financial results and providing advice based on those results.
Jeff also has a long history of helping individuals manage their taxes and plan their finances including:
Income tax planning and strategy.
Filing quarterly and annual taxes.
General financial and planning advice.
Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.
Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.
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