When a taxpayer takes out a loan, the loan proceeds aren't included in the taxpayer's income since they aren't income; they are a debt, and the taxpayer is obligated to repay the lender. When the lender cancels or forgives the debt, the taxpayer may have to include the canceled amount in income for tax purposes, depending on the circumstances, since they no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to the taxpayer and to the IRS on Form 1099-C.
In general, the cancellation of debt results in taxable income. Certain exceptions to the taxable income rule apply, such as when the taxpayer is in bankruptcy, the taxpayer is insolvent, or the cancellation of debt is qualified principal residence indebtedness. If none of the exceptions apply, the cancellation of debt income is included in income in the year the debt is canceled.
You must report any taxable canceled debt as ordinary income. The various forms to be used for reporting taxable income follows:
- Form 1040 or Form 1040NR, if the debt is a nonbusiness debt;
- Schedule C (Form 1040), (or Schedule C-EZ (Form 1040)), if the debt is related to a nonfarm sole proprietorship;
- Schedule E (Form 1040), if the debt is related to nonfarm rental of real property;
- Form 4835, if the debt is related to a farm rental activity for which you use Form 4835 to report farm rental income based on crops or livestock produced by a tenant; or
- Schedule F (Form 1040), if the debt is farm debt and you are a farmer.
Some of the most common situations when cancellation of debt income is not taxable involve the following:
- Gifts and bequests.
- Taxpayer insolvency, i.e., the total of the taxpayer's liabilities exceeds the fair market value of their assets immediately before the cancellation of the debt.
- When the payment of the liability would have given rise to a deduction to a cash-basis taxpayer.
- Student loans where certain debts are canceled in return for public service.
- Loan forgiveness as part of a program that helps provide health services in certain areas.
- Price reduced after purchase. If the seller reduces debt owed for property purchased, the reduction is generally treated as a purchase price adjustment that reduces basis.
- The cancellation takes place when the taxpayer is insolvent, to the extent the taxpayer is insolvent.
- Pay-for-Performance Success Payments under the Home Affordable Modification Program (these payments reduce the principal).
- Student loan discharged due to either death or total and permanent disability of the student.
- The debt is qualified farm debt owed to a qualified person.
- The debt is qualified real property business debt.
- The discharge of certain indebtedness of a qualified individual because of the Midwestern disasters. See Publication 4492-B.
To enter Form 1099-C in TaxSlayer ProWeb within the return select:
- Federal Section
- Income
- Less Common Income
- Cancellation of Debt
- Cancellation of Debt (Form 1099-C)
Form 982 - Reduction of Tax Attributes
When an individual has a debt that has been discharged, the amount that was discharged is generally treated as taxable income to the individual. Under certain circumstances, this amount can be excluded from income, and therefore not taxed. In order to report the exclusion, the taxpayer must file Form 982 with their tax return.
The IRS has a tool called the Interactive Tax Assistant that can help determine if cancelled debt on the taxpayer's personal residence is taxable.
To enter Form 982 in TaxSlayer ProWeb from within the return select:
- Federal Section
- Income
- Less Common Income
- Cancellation of Debt
- Exclusions (Form 982)
Note: This is a guide to entering cancellation of debt into the TaxSlayer ProWeb program. This is not intended as tax advice.
Additional Information:
Publication 544, Sales and Dispositions of Other Assets
Publication 908, Bankruptcy Tax Guide
Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments