Relief from your obligation of debt should mean you are in the clear, right? Not always. Cancellation of debt can trigger a taxable event on your tax return.

Cancellation of debt (COD) occurs when a lender forgives or discharges all or part of a debt that a taxpayer is legally obligated to repay. Whether your lender agrees to change the original terms of the loan or completely dismisses the amount owed, COD can look different to everyone.

Tax Treatment

In most cases, debt relief is considered taxable income and must be reported in the year the forgiveness occurred. However, there are certain exceptions to reporting cancelled debt as taxable income, such as:

  • Debts canceled as a gift, bequest, devise, or inheritance
  • Certain student loan cancellations (such as public service)
  • Amounts that would be deductible if paid (for cash-basis taxpayers)
  • Qualified purchase price reductions given by the seller of a property to the buyer
  • Debt canceled in a Title 11 bankruptcy case
  • Debt canceled to the extent the taxpayer is insolvent
  • Qualified farm indebtedness
  • Qualified real property business indebtedness
  • Cancellation of qualified principal residence indebtedness (subject to specific requirements and limitations) 

What to Look Out For

If a debt of $600 or more is canceled, the lender is generally required to issue Form 1099-C, Cancellation of Debt, to the debtor and the IRS. The form will show the amount of debt canceled and date of cancellation.

Even if you qualify for one of the exclusions above, you may have adjustments to report on your tax return related to the debt cancellation.

Our clients have seen an uptick of IRS notices claiming they did not report the COD on their return when they did. It is always in your best interest to alert your tax preparer of any debt relief received and the related circumstances.

If you have further questions about this topic as it relates to your tax situation, please contact your KT tax advisor.