When a lender cancels your debt, you may have to report this as taxable income on your federal income taxes, unless there is an exception. If you're required to report the cancelled debt, the lender will send IRS Form 1099-C to you.
Why Are Debts Cancelled?The lender may cancel your debt for a number of reasons:
- The statute of limitations expired and the court entered a judgment to this fact.
- You've made an agreement with the lender to cancel the debt, e.g. debt settlement.
- The lender has a business policy of discontinuing collection activity after a certain period of time.
Tax Income Reporting Exclusions
There are certain situations in which your debt can be cancelled, but you don't have to report it as taxable income.
- The debt was discharged in bankruptcy (unless the debt was incurred for business or investment purposes).
- Student loans that are forgiven by an educational institution that's tax-exempt and you work for a certain number of years for a qualified employer. (See IRS Publication 970, Chapter 5 for more information.)
- The debt was from a mortgage on a primary residence lost in foreclosure, sold in a short sale, or from a restructured mortgage. You'll still need to include this forgiven mortgage on your tax return, but on Form 982, and shouldn't face any tax penalty on it. See IRS Publication 908 for more information.
- You were insolvent by least the amount of the cancelled debt at the time the debt was cancelled. Being insolvent means your liabilities outweigh the fair market value of your assets. In other words, you had a negative net worth when the debt was cancelled. To take the insolvency exclusion for cancelled debt, you need to file IRS Form 982.
State Law For Cancelled Debts
Your state's tax law for cancelled debts may differ from that of federal tax law. Consult a tax professional, e.g. an accountant or attorney, to confirm your state's tax law about reporting cancelled debts as taxable income.