Having outstanding debt can hurt you in a variety of ways. Debt is defined as any amounts owed for property or services, whether you are personally liable or there is property securing the amount of the debt. If debt is secured by property and is canceled, whether fully or partially, as a result of foreclosure, repossession, abandonment, voluntary surrender, or loan modification, you will receive a Form 1099-C, Cancellation of Debt at tax time. This form documents the canceled amount as gross income, as long as there are no exceptions or exclusions.
You are required by the IRS to report the taxable amounts of cancelled debt, as you may be held liable for these amounts, even if you don’t receive a Form 1099-C. You report these amounts on your regular Form 1040 when filing your taxes.
If your debt is secured by property which is taken by the creditor as payment of your debt, you’ll need to consider it as sold property in the eyes of the IRS. This means your property may be subject to taxable gains or losses, and you need to understand the different taxes that apply to property sold for capital gains. This is a separate taxation from the canceled debt, and will be taxed separately.
If your canceled debt meets the following requirements, it may be an exception to inclusion in your gross income at tax time:
- Any amount excluded by law, such as gifts, devises, inheritance and bequests
- Qualifying student loan debt
- Deductible debt paid as cash to a taxpayer
- A qualified purchase price reduction offer from the seller
- Reduction of the principle mortgage amount by means of the Home Affordable Modification Program
Certain cancelled debts are always excluded from your gross income including:
- Title 11 bankruptcy
- Insolvency
- Qualified farm debt
- Qualified real property business cancellation
- Qualified principle residence debt cancellation
Homeowners who had their mortgages foreclosed upon can benefit from tax relief for canceled debt on principle residences. This relief offers an exclusion of up to $2,000,000 ($1,000,000 if married filing separately) of canceled qualified principal residence debt.
You should always check with your creditor to verify your current situation, especially if debt collect attempts are still in progress but you receive a Form 1099-C. Be sure to double check the Form 1099-C for correctness and contact your lender if there are any errors. You can also file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to determine which tax attribute are reduced due to your canceled debt.
