One form of income that often catches taxpayers unaware is cancellation of debt. These are generally reported to the IRS through forms 1099-C or 1099-A. Settling a credit card debt with a bank for an amount less than what was owed might relieve you from one liability, but doing so potentially creates another liability to the federal and state taxing authorities. I have seen many cases where this liability does not even enter a taxpayer’s awareness until they receive a letter from the IRS stating they owe additional tax a couple of years after a return is filed.
Internal Revenue Code § 61(a)(12) states that gross income includes income from the discharge of indebtedness. Any time a creditor either voluntarily or involuntarily reduces a legally enforceable debt, the debt cancelled is counted as income. Discharge of indebtedness, also known as cancellation of debt income, can occur through transactions such as:
- Credit card or credit line reduction or forgiveness
- Foreclosure or short-sales of real property
- Repossession of personal property,
- Student loan forgiveness
- Relief or reduction of medical debt
Some of these transactions can become rather complex because a cancellation of debt may also involve treating some or all of the transaction as a sale of an asset. This is most often seen in foreclosures and repossessions.
The good news is there are many potential avenues to exclude cancellation of debt from income if certain qualifications are met. There is one cautionary note, however. In many cases, these exclusions do not outright relieve taxpayers from paying tax, but only delay the taxation. Internal Revenue Code § 108(b) requires that any cancellation of debt income excluded from income reduces certain tax attributes. In this case, these tax attributes are future tax benefits such as loss and credit carryovers, and the basis of depreciable and non-depreciable assets. Reducing any of these can increase your tax liability in the future.
Over the coming weeks, we’ll talk about the different types of transactions, and the available exclusions.