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Rev. date: 01/01/2011

Canceled Debt – Is It Taxable or Not?

Tax Topic 431
In general, if you are liable for a debt that is canceled, forgiven, or discharged, you will receive a Form 1099-C, Cancellation of Debt, and must include the canceled amount in gross income unless you meet an exclusion or exception. If you receive a Form 1099-C but the creditor is continuing to try to collect the debt then the debt has not been cancelled and you do not have taxable cancellation of debt income.
A debt includes any indebtedness whether you are personally liable or liable only to the extent of the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, a repossession, a voluntary return of the property to the lender, abandonment of the property, or a principal residence loan modification. You must report any taxable amount of a cancelled debt for which you are personally liable, as ordinary income from the cancellation of debt, on Form 1040 or Form 1040-NR and associated sub-schedules, as advised in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals). You must report the taxable amount of a taxable debt whether or not you receive a Form 1099-C.
Caution: If your debt is secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have a reportable gain or loss. The gain or loss on such a deemed sale of your property is a separate issue from whether any canceled debt also associated with that same property is includable in gross income. See IRS Publication 544, Sales and Other Dispositions of Assets, for detailed information on reporting gain or loss from repossession, foreclosure or abandonment of property.
Canceled Debts that meet the requirements for any of the following exceptions or exclusions are not taxable.
Canceled Debt that Qualifies for EXCEPTION to Inclusion in Gross Income:
  1. Amounts specifically excluded from income by law such as gifts or bequests
  2. Cancellation of certain qualified student loans
  3. Canceled debt that if paid by a cash basis taxpayer is otherwise deductible
  4. A qualified purchase price reduction given by a seller
Canceled Debt that Qualifies for EXCLUSION from Gross Income:
  1. Cancellation of qualified principal residence indebtedness
  2. Debt canceled in a Title 11 bankruptcy case
  3. Debt canceled during insolvency
  4. Cancellation of qualified farm indebtedness
  5. Cancellation of qualified real property business indebtedness
The exclusion for "qualified principal residence indebtedness," provides canceled debt tax relief for many American home owners involved in the mortgage foreclosure crisis currently affecting much of the country. The exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of "qualified principal residence indebtedness".
Generally, if you exclude canceled debt from income under one of the exclusions listed above, you must also reduce your tax attributes (certain credits, losses, and basis of assets) by the amount excluded. You must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the exclusion and the corresponding reduction of certain tax attributes.
Refer to Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), for more detailed information regarding taxability of canceled debt, how to report it, and related exceptions and exclusions. Additional information can also be found in Publication 525, Taxable and Nontaxable Income.