Sometimes things happen in life that are outside of our control. Medical bills, job loss, and catastrophic uninsured damage to a home are just a few things that could happen to each and every one of us. When unwelcome events like these happen it may make paying bills harder and can ultimately lead to losing a car or house in exchange for debt forgiveness. Although you would be relieved of your obligation to pay back your debt, there is another party waiting in the distance to collect; the IRS.
What is Cancelled Debt and How is it Reported?
Cancellation of Debt "COD" income, as the IRS defines it, is any debt for which you are personally liable, which is forgiven or discharged for less than the full amount owed. The debt is considered canceled in whatever amount remains unpaid. Creditors are responsible for reporting cancelled debt to taxpayers for amounts $600 or greater on form 1099-C. Taxpayers who receive COD income (regardless of whether or not they receive a 1099-C) must report the cancelled debt on their income tax return and pay income tax for the amount forgiven.
What to Do if You Receive COD Income
Like anything else tax related, don’t ignore any tax forms you receive, including a 1099-C. Remember, anytime you receive a tax document from a third party, there is a very high likelihood that the IRS has also received a copy. The IRS is expecting that you will report all tax information, and if you don’t, they’ll correct your return for you and throw on some penalties & interest for their trouble. Even if you don’t receive a 1099-C, you are still responsible for claiming any COD income on your return.
There are however some exceptions and exclusions as to when COD income is taxable (listed below). Visit the IRS website for more information about each.
Exceptions (do not reduce tax attributes)
1) Gifts, Bequests, Devises, and Inheritances
2) Student Loans
3) Deductible Debt
4) Price Reduced After Purchase
5) Home Affordable Modification Program
Exclusions (may reduce tax attributes)
3) Qualified Farm Indebtedness
4) Qualified Real Property Business Indebtedness
5) Qualified Principal Residence Indebtedness
Before you get too excited, it’s important to understand that the exceptions and exclusions listed above exist in a very narrow set of circumstances and the rules have changed numerous times over the last decade. Discuss any tax ramifications with your tax advisor if you have any COD income. I will go into more detail on two of the most common types of COD income in the next section.
Mortgage Relief and Consumer Credit
The most common types of COD income include Qualified Principal Residence Indebtedness and consumer credit. For taxpayers whose primary homes are foreclosed or sold in a short sale, they are required to report COD income, but may not be responsible for paying income tax on the COD income they receive (effective through December 31, 2016 as of the time of this writing). This is thanks to the Mortgage Forgiveness Debt Relief Act of 2007. The good news here is that there is talk (as of the time of this writing) to extend the Qualified Principal Residence Indebtedness relief permanently for all future years.
For consumer credit (such as credit cards), taxpayers can almost always expect to pay income tax on any COD income they receive, unless one of the exceptions or exclusions from the above section apply. In instances where a car or boat is repossessed and a loan is forgiven there may also be tax consequence. These are common examples of when taxpayers are blindsided. Remember this if you ever need to negotiate with your credit card company to reduce an amount due.
One more note of caution. Although there are exceptions and exclusions at the federal level, some states may still require that income tax be paid on COD incomeregardless of the federal exclusion. Again, consult with your tax advisor to whether this pertains to your situation or not.
How Much Will I Owe?
If you find yourself faced with a situation where you know you’ll have to pay tax on COD income then it might be wise to plan ahead. COD income is taxed at your marginal income tax rate. So for example, a taxpayer with COD income of $10k in a 15% tax bracket (plus state) will face at least $1,500 in additional income tax related to the COD income. In a separate example, if you had a car with a $20k note on it and you returned the vehicle worth $18k and were forgiven for your debt, only the $2k difference would be taxable at your marginal tax rate. What these examples tell us is if you’re going to attempt to have debt cancelled or forgiven, it would be ideal to do it as early in the year as possible to afford you more time to save up to pay your tax bill.
Debt forgiveness has more than just an income tax effect. It can also impact your credit score. Sometimes it may make more sense to get out from under a loan rather than try to endure the hardship of paying it back. In those cases, COD income and lower credit scores may be worth the trade-off. However, given all of the adverse consequences of debt forgiveness, taxpayers should consider debt forgiveness as a strategy only as a last resort.
I hope this was informative to readers. It’s not common that taxpayers receive COD income but it is a growing trend and more people are finding themselves faced with the issue. Feel free to leave comments or questions below!