If one of your creditors canceled a debt you owe, you'll likely receive a Form 1099-C this year. A number of exceptions and exemptions can eliminate your obligations to pay tax on the canceled debt.
If you receive a Form 1099-C this year, it’s because one of your creditors canceled a debt you owe, meaning the company writes it off and you no longer have to pay it back. In some cases, you may need to include the amount of debt your 1099-C reports on your tax return as income. However, there are a number of exceptions and exemptions that can eliminate your obligation to pay tax on the canceled debt.
Canceled debt exceptions
One exception includes the debts you no longer have to repay because of a gift or a bequest made in a will. For example, suppose you borrow money from a friend and sign a promissory note. If your friend passes away and relieves you of your obligation to repay the loan in his will, the debt cancellation isn’t taxable.
A second exception applies to the cancellation of student loan debts resulting from your employment with a government agency or with an educational institution. And if your mortgage balance is reduced under a Home Affordable Modification Program, you don’t have to report it on your tax return.
Deductible debt exception
Some debt payments you make may be deductible on your tax return. For example, if you operate a business as a sole proprietor, you can deduct many of your business expenses on Schedule C after you pay them, if you’re using the cash method of accounting. Therefore, if you incur business expenses on credit and your obligation to pay them is canceled, you don’t have to report it on your tax return. However, once the debt is canceled you can’t include the expenses it covers in your deductions on Schedule C, which can ultimately increase your taxable net profit.
Canceled debt exclusions
If your canceled debt doesn’t qualify for one of the exceptions, you should then determine if an exclusion applies to your situation. Exclusions commonly cover debts canceled on your primary residence, in a Chapters 7, 11 or 13 bankruptcy or other situations where you’re insolvent at the time the debt is canceled. You are insolvent if your total debt is more than the fair market value of your personal assets.
For example, suppose your credit card company cancels your outstanding balance of $10,000 at a time when your only asset is an investment account worth $25,000 and your other debts total $50,000. In this case, you owe more than you have, so you may qualify for the insolvency exclusion with regards to the $10,000 canceled credit card balance.
How to report
If you do not qualify for an exclusion or exception, your canceled debt is taxable and must be reported on the “other income” line of your tax return or on Schedule C if it relates to your sole proprietorship business. If you qualify for an exception or exclusion, you don’t report your canceled debt on your tax return. However, when using an exception, you may need to file a Form 982 to reduce your tax basis, or cost, in the underlying property if the debt relates to your insolvency or bankruptcy. This reduction in basis can increase the taxable gain that you'll recognize when you sell the property.
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