What is Cancellation of Debt?

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Debt cancellation usually results from loan forgiveness, negotiation with creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more, debt reliefDebt ReliefDebt relief is defined as the process of complete or partial forgiveness of debt taken on by individuals, corporations, or nations, with the goal of stopping or slowing debt growth and providing relief to the debt taker.read more schemes, or filing bankruptcyBankruptcyBankruptcy refers to the legal procedure of declaring an individual or a business as bankrupt.read more. In the event of such cancellation, the debtorDebtorA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more is liable to pay tax on the amount of debt forgiven. However, IRS (Internal Revenue Service) allows some exceptions and exclusions to the rule. Creditors must report the canceled debt to the debtor on a 1099-C Form.

Key Takeaways

  • Cancellation of debt (COD) occurs when the moneylender relieves the borrower from the debt obligation, partially or completely.Borrowers may seek debt relief through negotiations with lenders, foreclosure, debt relief programs, or bankruptcy. Legally, COD relieves the debtor of the debt obligation but requires reporting the forgiven debt as taxable income while filing tax returns (Form 1040). However, the IRS lays down certain exceptions to filing requirements. A lender who has canceled a debt of $600 or more must file Form 1099-C for each such borrower.

Cancellation of Debt Explained

Debtors are lawfully obliged to repay any amount borrowed from lenders within the agreed time period. However, if due to unforeseen circumstances, the borrower is unable to return any amount of the debt, and the creditor agrees to write it off as bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read more. In that case, such a sum of money is referred to as canceled debt.

Note that either borrower or moneylender can initiate debt cancellation. Any type of debt like real estate, credit card overdue, student loans, medical bills, or IRS debt can qualify for debt cancellation.

Forgiveness of real estate debt occurs due to reclamation, foreclosureForeclosureForeclosure refers to the legal action taken by the lender when the borrower fails to repay the amount due against the mortgage loan. The lender can take the possession of mortgaged asset or property or resale it to a third party for recovering the default loan amount.read more, discretionary land surrender to the mortgagee, contract alteration, or property withdrawal. Eligible candidates can seek partial or full student loan forgiveness. In addition, credit card companies may choose to forgo some amount of outstanding debt for immediate partial settlement.

Usually, borrowers negotiate with lenders themselves or take the help of debt relief companies to reach mutually agreeable debt settlementDebt SettlementDebt settlement is an arrangement between a lender and a borrower in which the borrower pays a lump sum or one-time payment that is less than the actual amount due in order to settle the debt once and for all.read more terms. In other cases, they resort to filing for bankruptcy.

The IRS considers canceled debt as taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more and requires the borrower to pay taxes on the discharged debt. Therefore, debt cancellation provides relief to the debtor only from debt, not tax liability.

Exceptions to Cancellation of Debt

Exceptions

According to IRS, a canceled debt must be reported as income. However, it offers certain exceptions to the rule.  The following amounts are not considered to be cancellation of debt income:

  • Debt is canceled as a gift, inheritance, devise, or bequest.Student loan canceled due to meeting specific work requirements.Certain student loans discharged after December 31, 2020 and before January 1, 2026.Amount discharged under assistance programs for student loan repayment.Canceled debt that would be deductible only when paid by the cash basis taxpayerTaxpayerA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more. A qualified discount on the purchase price offered by the property seller to its buyer.Cancellation of debt from certain private, educational, or federal student loans.

Exclusions

The IRS excludes the following canceled debt from being reported as income:

  • COD to the extent insolventCOD in a Title 11 bankruptcy caseQualified real estate business obligation canceledQualified farm liability canceledQualified main residence indebtedness canceled

While excluding canceled debt from income, debtors must reduce specific tax features by the sum excluded. This includes losses and carryovers, certain credits and carryovers, the basis of assets, etc. To cancel qualified main residence indebtedness, debtors must only decrease their basis in residence. 

A Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), must be attached to the tax return. This lets debtors report the qualified amount for exclusion with any relative reduction of tax features. 

Is Canceled Debt Taxable?

Canceled debt attracts tax on it. Thus, the debtor must report the debt discharged as income in their tax returns in the cancellation year. Failure to do so may result in penalties imposed by the IRS.

When creditors agree to forgo any sum due and cancel the same, they are responsible for sending a 1099-C Cancellation of debt form to the debtor to acknowledge the cancellation. However, irrespective of the receipt of Form 1099-C, the debtor is obliged to file returns.

Debtors must usually report the canceled debt as ordinary incomeOrdinary IncomeOrdinary income refers to an individual’s or business entity’s earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more from debt forgiveness on the below-mentioned forms. If it is a business debt, report on an applicable schedule. However, record it as other income if it is non-business debt.

  • Form 1040, US Individual Income Tax ReturnForm 1040-SR, US Tax Return for SeniorsForm 1040-NR,  US Non-resident Alien Income Tax Return

Example

Suppose A borrows $10,000 from B, promising to return by the end of 2021. A repays $2000, but he is unlikely to pay any further due to a severe financial crunch. So he approaches B and requests him to forgo $3000 of his debt in a settlement of $5000 to him immediately.

B agrees to the condition, receives $5000, and cancels the remaining $3000 ($10,000 – $5000 -$2000). B reports $3000 canceled debt on Form 1099-C. B sends the form to A by January 31, 2022. Therefore, he must report $3000 as taxable income on his tax returns for the year 2022. However, this rule has several exceptions and exclusions, as discussed above.

Debt Secured by Property/Asset

If the creditor confiscates the debt-securing asset for discharging a full or partial liability, it is inferred as property sold to the creditor. Therefore, the reporting of the canceled debt as ordinary income for taxation depends on whether the debt was recourseDebt Was RecourseRecourse debt is one of the forms of loans that are less riskier for a lender to invest in because it allows the lender the right to recover the investment using the collateral asset if the borrower fails to make a payment or meet an outstanding liability specified in the loan agreement.read more or non-recourse. 

Recourse Debt

Ordinary income from COD is the outstanding debt in excess of the asset’s fair market value (FMV). The difference between FMV and the adjusted basis (cost, in general) will be the profit or loss on the asset’s disposal. 

Non-recourse Debt

In this case, there is no ordinary income from COD. The difference between the outstanding debt and the asset’s cost will be the profit or loss on its disposal. 

This has been a guide to Guide to What is Cancellation of Debt. We discuss cancellation of debt as a taxable income, exceptions on student loan, & meaning of 1099-C. You may also have a look at the following articles to learn more –

A – Debt cancellation is typically a good concept for debtors in bad shape. It does not adversely affect the credit score and releases the borrower from the debt obligation. However, they must report it as an ordinary income on the tax return statement.

A – The creditors may settle for debt cancellation if it remains unpaid for a long time. They may partially relax the debt in return for immediate payment of the remaining amount. In doing so, they must send Form 1099-C to the debtor and mark the debt off their book.

A – The IRS specifies that almost any canceled, discharged, or forgiven debt becomes an ordinary taxable income for the debtor. Hence, debtors receive Form 1099-C Cancellation of Debt from the creditor to mention the same. The form mentions the canceled amount, the date of cancellation, etc.

  • Debt to Income RatioDebt RestructuringDebt Settlement