Cancellation of debt income

Over the years I have received many calls from surprised taxpayers that their debts written off (COD Income), whether it be from home loan or credit card debt, created income that needed to be reported on the tax returns as taxable income. The basic theory for all taxation, is that if you are wealthier, then there is a good chance you need to pay taxes on that wealth.

When a person borrows money and buys an asset (for a car or home, for example), they typically do not think if they do not repay that loan that it creates income, but under the tax rules it may. As an example, say you borrow $20,000 from the bank and buy a car. You run into bad luck, stop paying the loan, and the car loan defaults, and they take the car. After selling the cat, say you still owe $5000 on the loan after the car is sold. If they write-off the $5,000 it can create income since you received $20,000 and paid back $15,000, so you are $5,000 richer and that $5,000 of wealth is subject to tax. The tax form that you would receive in these cases is a form 1099-C, Cancellation of debt.

COD Income

There are a few exceptions to this rule, for instance, if you are in bankruptcy or insolvent (assets less than liabilities) when the debt is written off. If either of these exceptions are your case, then the write-off of the tax debt would not be taxable. The lender also needs to be a commercial lender and not a family member or friend. If you fail to pay the family member or friend, then the write-off would be viewed as a gift from them to you. The other main exception is if you merely guarantee debt, by co-signing, then if the main borrow defaults typically you did not become wealthier and you would not have to pay tax on that transaction. The last major exception is if under the terms of the loan, the only recourse of the lender has is to take back the property to satisfy the debt. They call this non-recourse debt, and a write down of non-recourse debt is typically not taxable.

One exception to the above rules applies under the Mortgage Forgiveness Debt Relief Act of 2007. It does seem like ages ago, but it applied to transactions in tax years 2007 to 2014. It allowed taxpayers to exclude from income debt write offs related to debt of their homes that was reduced through debt restructurings, or through a foreclosure proceeding. The amount of the income exclusion could be $1M per taxpayer. The debt write-off also had to relate to a decline in the value of the home, which was common in the financial crisis we suffered during the 2007 to 2009 time period. The amount of the debt write-off then reduced the basis you has in the property, but normally this was not overly concerning since for a married couple the first $500K of gain was tax free. If you want to read more about this, please visit https://www.irs.gov/newsroom/home-foreclosure-and-debt-cancellation.

If the write off of the tax debt results in taxable income, the resulting taxes can be paid, or a tax payment plan or offer in compromise can be filed to reach a tax settlement with the IRS and protect your rights. Therefore, there are ways to fix this issue even if you have income from a debt being cancelled.