When you are liable for a loan but can’t repay it, some lenders will forgive the debt. What many borrowers don’t realize is that this cancellation of debt (COD) often results in taxable COD income in the year of forgiveness. The lender usually will issue a Form 1099-C to report the cancelled debt. If you receive one, don’t ignore it. Be sure to give it to your tax preparer and discuss the circumstances surrounding the loan.
If you have cancelled debt but are bankrupt or insolvent, you may exclude the income on your tax return. To prove insolvency, you must show that your liabilities exceeded the fair market value of your assets immediately before the debt discharge. The amount of forgiven debt that can be excluded cannot be more than the amount your liabilities exceeded the value of your assets.
Congress passed the Mortgage Forgiveness Debt Relief Act in late 2007 to provide some relief for borrowers who can’t pay their mortgages. If you have forgiveness of debt on the mortgage of your qualified principal residence due to foreclosure or short sale, you may not have to include the COD income on your tax return. The maximum amount of debt forgiveness eligible for exclusion is $2 million. This relief is available for tax years 2007 through 2009.
Even with this special exclusion, many taxpayers are going to have to report taxable COD income, or taxable capital gain income, or both, as the result of residential foreclosures and short sales. Equity debt is going to be a common hang up, because only cancelled acquisition and improvement debt may be excluded from tax under the congressional relief act. Any borrowing done for other purposes (auto purchase, education, pay off credit cards, buy a second home or investment property, etc.) is considered equity debt. Expect cancelled equity debt to be taxable, except in cases of bankruptcy or insolvency.
California residents should expect to pay state income tax on COD income. Principal residence debt forgiveness will be excluded only if the legislature conforms to federal law by August 31.
Debt forgiveness is a complex topic and every situation is unique. If you are facing a possible foreclosure or short sale, consult your tax advisor to understand and prepare for the tax consequences.