Why is ‘Canceled Debt’ Taxable? (and what you can do about it)
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For a lot of people in the US, owning a credit card is a natural thing. So are credit card payments. Unfortunately, it is really easy to fall behind on those payments. If you fall far enough behind, you can negotiate with the credit card company and they may cancel some of the debt you owe. If they cancel some or all of your remaining debt, they will send you a 1099-C form in the mail. Then, when you go to get your taxes done for that year, your tax preparer adds that amount of canceled debt as income on your return. That, in turn, will affect how much of a refund you get, or how much you owe.
But, why is cancelled debt taxable??
This seems counter intuitive. You are paying a debt with the money you earn. Money that is already taxed. For years this is the way I have viewed canceled debt and it blew my mind that the IRS was able to double tax a person in this way. It turns out that I was wrong.
The IRS defines cancellation of debt as follows.
If you owe a debt to someone [a credit card, financial institution, etc…] who cancels or forgives all or some of the debt, you’re treated as having received income for income tax purposes, and you may have to pay tax on this income.
https://taxpayeradvocate.irs.gov/get-help/cancellation-of-debt
Apparently, the way the IRS looks at it, you were given money by the credit card company to purchase stuff. Sort of like a bonus you might get at work. If you don’t pay that money back, the IRS considers that amount as income. When viewed as income, the IRS says that needs to be included in your overall gross income. which raises your tax liability. However, depending on your situation, that cancelled debt may not be taxable.
There are several EXCEPTIONS to the requirement that you include canceled debt in income. Canceled debt that’s not included in income can be:
- Debt that’s canceled as a gift, bequest, devise, or inheritance;
- Certain cancellations of student loans;
- A payment of the debt that would have been a deductible expense for the tax year in which it was paid; and
- For example: Your mortgage company cancels the mortgage on your home. Part of the forgiven debt is interest that you could have deducted on your tax return if you’d paid it. The amount of interest forgiven isn’t included in income.
- A qualified purchase price reduction given by a seller.
Canceled debts that qualify for EXCLUSION from gross income are:
- Debt canceled in a Title 11 bankruptcy case;
- Debt canceled during insolvency;
- You’re insolvent when your total liabilities (what you owe) exceed (more than) the value of your total assets. You may use IRS Publication 4681, Insolvency Worksheet, to determine if you were insolvent just before the cancellation.
- Cancellation of qualified farm indebtedness;
- Cancellation of qualified real property business indebtedness; and
- Cancellation of qualified principal home indebtedness.
- This exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of canceled “qualified principal residence indebtedness”.
The next time you get a 1099-C, make sure your preparer knows about these exceptions and exclusions.