Cancellation of Debt And Your Income Tax Return

Debt happens! We all incur debt at some point in our lives even in small amounts and sometimes debt can not be repaid. When that happens and creditors have given up trying to collect money owed them and take the amount of un-repaid loans as a loss they issue a 1099-C Cancellation of Debt. Beware that just because your creditor has forgiven you does not mean you are completely off the hook.
One man's loss is another man's gain or in this case your gain in terms of income. The IRS views cancelled debt as income and you have to pay taxes on that income. That means that if you had a twenty thousand dollar credit card bill that was forgiven, the debt cancelled, in all likelihood you just had twenty thousand dollars added to your income.
There are exceptions, but if you are issued a Form 1099-C, Cancellation of Debt you must proceed with caution. One of ways that happens is when a creditor issues a 1099-C and then continues to try and collect the money you owe them. Well in that case they really haven't forgiven anything and you still owe them so it is not income, just be sure you can document it or it may not be allowed.
The IRS considers a debt to be the full amount you owe minus the value of any property securing the debt, collateral that is taken back by the creditor. For example if you buy a racehorse for $100,000 with a loan for the full amount and the horse gets repossessed and is only worth $10,000 because he won't run. The IRS says you must report the $90,000 difference as ordinary income and pay the tax due on that income.
There are other exceptions and exclusions and they are:
Canceled Debt that Qualifies for EXCEPTION to Inclusion in Gross Income:
Canceled Debt that Qualifies for EXCLUSION from Gross Income:
"Qualified principal residence indebtedness" your primary residence, home foreclosures have their own exclusions up to two million dollars ($1 million if married filing separately) that offer relief to those caught up in the home foreclosure crisis. The rule applies to "qualified principal residences" only. Rental properties and vacation homes may not be included in this exclusion.
If you can exclude your cancelled debt from your income based on one of the exclusions or exceptions we talked about earlier you must also reduce your tax attributes (a kind of loss) by the amount you excluded. The IRS requires that you file a Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)"
When it comes to debt cancellation and your tax return I recommend that you consult a qualified CPA to protect yourself from a bigger tax and debt nightmare. At the very least I suggest that you read IRS Publication 4681, "Canceled Debts, Foreclosures, Repossessions and Abandonments (for Individuals).

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