Cancelled debt and income taxes, part 1: Is a forgiven debt really income?
Forgiveness is of course an important religious and humanistic principle. In the Gospels, Jesus speaks of the need to forgive “seventy times seven.” And cotemporary psychologists often counsel people on the importance of letting other peoples’ past failings go.
In tax law, however, forgiveness or cancellation of debt has some very particular meanings. In this two-part post, we will discuss the tax implications of cancelled debt.
In part one, we will address the question of whether forgiven debt is treated as income. In part two, we will focus on a specific scenario: the cancellation of mortgage debt.
Is forgiven debt really treated as income for tax purposes?
The answer is that cancelled debt is generally taxable. There is even a particular 1099 form – 1099-C, to be precise – devoted to this. If a creditor lets you off the hook, they are supposed to send 1099-C to the IRS and to you.
And you are supposed to report the amount as income. If the debt is business debt, a separate schedule will be required on your tax form for this.
This is true even if the forgiven amount is for only part of the debt.
There are, however, several important exceptions to the general rule that a cancelled debt is taxable income.
One exception involves bankruptcy. If your debt is discharged through Chapter 7 bankruptcy, there is no tax bill that gets triggered when the debt goes away.
Mortgage debt forgiveness is another possible exception. We will discuss that issue in part two of this post.