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The economy is slowly improving in 2010, but 2009 was a rough year for many businesses and individuals. Generally, financially distressed borrowers may have had a portion of their debt or all of their debt canceled or forgiven by their lenders. Many taxpayers do not realize that debt cancellation or forgiveness is considered income and should be reported on their tax return. However, there are numerous exceptions that, if they apply, allow debt cancellation or forgiveness to be left off an income tax return.

General Rule

The Internal Revenue Code specifically includes discharge of indebtedness in the calculation of gross income. However, there are numerous exceptions and exclusions to the general rule.

Gift Exception

If the debt that has been canceled or forgiven is from a private lender, such as a relative or friend, and is intended as a gift, then there is no income. The same goes for debt canceled or forgiven by a private lender’s last will and testament.

Student Loan Exception

Certain student loans that are forgiven in specific circumstances are exempt from being included in gross income of a taxpayer. An example of this exception is when a doctor, nurse or teacher agrees to serve in a rural or low-income area in exchange for cancellation of their student loans. The cancellation, as long as it meets certain requirements, will not be included as gross income for the taxpayer.

Deductible Debt Exception

Debt that is forgiven or canceled that could be claimed as a deduction on the taxpayer’s tax return is not included in gross income. For example, if a lender cancels home mortgage interest that an individual taxpayer could deduct on a Schedule A, then the cancellation is not included in gross income.

Discharge of Debt Through Bankruptcy

Debt canceled by a discharge of indebtedness in a Title 11 bankruptcy case is not included in gross income of the taxpayer, if the taxpayer is under the court’s jurisdiction and the discharge is granted by the court or in a court-approved plan. There are other, more complex rules that go along with this situation, so if you have had debt canceled by a discharge of indebtedness through bankruptcy, consult your tax advisor.

Discharge of Qualified Principal Residence Debt

Any debt that is discharged on a qualified principal residence is excluded from the taxpayer’s gross income. This exclusion applies when individuals restructure their acquisition debt, lose their principal residence to foreclosure or sell their principal residence in a short sell (where proceeds are insufficient to cover the remaining mortgage and the lender cancels the balance). As with discharge of debt through bankruptcy, there are rules that make this transaction more complicated. Your tax advisor can offer specific guidance.

Other Exceptions

In addition to the above-mentioned exceptions, there are several other exceptions to consider that are more complex:

  • Discharge of debt of an insolvent taxpayer
  • Discharge of qualified farm debt
  • Discharge of qualified real property business debt

Form 1099-C

A taxpayer who has had debt forgiven or canceled should receive a Form 1099-C from the federal government agency, financial institution or credit union that forgave the debt, as long as it is in excess of $600. The amount of canceled debt is shown in box 2, and any interest that is included in box 2 is shown in box 3. As previously mentioned, certain interest that is forgiven does not have to be included in gross income. If the taxpayer does not agree with the amount shown on Form 1099-C, they should contact the lender in writing, requesting a corrected Form 1099-C.

Nathan Sharp

Nathan Sharp works with a variety of firm clients, including individuals, family businesses, business owners, and various corporations. He earned his BS in accountancy, his master’s in accounting science, and his MST from Northern Illinois University.