If a creditor discharged $600 or more of debt and you received a Form 1099-C, you may be required to report the debt discharge as income on your tax return. Ironically, this can result in a hefty tax bill. Fortunately there are a few exceptions that apply. While there is no general “hardship rule,” if you can show that some of these exceptions apply, you may not have to pay tax on all or part of the amount.
Common Exceptions to COD Income Taxes
**If you qualify for any of the following exceptions, fill in and attach IRS Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness to your tax return.**
Gifts – If a debt is cancelled as a gift, a bequest, or as part of an inheritance, it is not generally considered income.
Student Loans – Some student loan debt may be cancelled if the student agrees to work for certain employers. For example, the Nurse Corps Loan Repayment Program supports RNs by paying up to 85% of their unpaid nursing education debt if they work full time in a high-need area or in an accredited school of nursing.
Bankruptcy – Filing for bankruptcy is stressful enough without having to pay tax on the significantly large amount that was discharged. If your debts were cancelled as a result of a title 11 bankruptcy, but not any other type, the debts are excluded from gross income. However, if you receive the Form 1099-C before you file for bankruptcy, you will still have to report the cancelled amount as income.
Insolvency – When you are insolvent, the amount of your debt is greater than the total amount of all your assets. You would subtract the amount of your assets from the amount of your debt, and the remaining amount is the extent to which you are insolvent. For example, if you have $150,000 of debt, and $130,000 of assets, you are insolvent by $20,000. If a creditor cancels $30,000 of your debt, you would not have to report $20,000 of that amount. Instead, you would only have to pay taxes on $10,000 of the cancelled debt.
Principle Residence – If you took out a loan to buy, build, or substantially improve your home and circumstances prevent you from being able to repay, you may be able to exclude that amount from your income. The exclusion may also apply to amounts cancelled on a refinanced mortgage if you used the proceeds from the mortgage to buy, build, or improve your main home.
These are just a few of the reasons debt income may be non-taxable. For more information on this topic, see IRS Publication 4681, or contact our office. Our skilled team of tax and accounting professionals would be happy to answer any questions you may have.