Key Takeaways
- The IRS recognizes certain exceptions to canceled debt rules, including gifts, bequests, inheritances, some qualified student loans, a qualified reduction in price offered by a seller, and any debt that, if paid, would have been a tax deductible item for the borrower.
- When a lender takes property that secured a debt as full or partial settlement of the debt, it’s considered a sale for tax purposes, not a forgiven debt.
- The IRS excludes some types of canceled debt, including debt canceled in a Title 11 bankruptcy or during insolvency, canceled qualified farm debt, and canceled qualified real property business debt.
- The Mortgage Debt Relief Act (2007 through 2020) and the Consolidated Appropriations Act (CAA) (through 2025) exclude as income any debt discharge on your primary residence up to $2 million under the Mortgage Debt Relief Act and up to $750,000 under the CAA.
Adding forgiven debts to income
If your forgiven debt is subject to taxation, you will usually receive a form 1099-C, Cancellation of Debt, from the lender, showing the amount of canceled debt. You’ll file the 1099-C with your federal tax return, and the amount of canceled debt is added to your gross income.
There are, however, exceptions and exclusions that may save you from the requirement to report canceled debt as part of your income.
Exceptions and exclusions
Not all canceled debt is subject to income tax. The IRS recognizes both exceptions to canceled debt rules as well as amounts that are excluded from gross income due to their origin.
Exceptions include:
- gifts, bequests or inheritances
- some qualified student loans
- any debt that, had it been paid, would have been a deductible item for the borrower
- a qualified reduction in price offered by a seller
- certain payments on the balance of a mortgage under the Home Affordable Modification Program
When a loan is secured by property, such as a mortgage where the home and land stand as collateral, and the lender takes the property as full or partial settlement of the debt, it is considered a sale for tax purposes, not a forgiven debt. In that case, you may need to report capital gains or losses on the “sale” of the property, but you will not need to add forgiven debt to your income.
Exclusions include:
- debt canceled in a Title 11 bankruptcy or during insolvency
- canceled qualified farm debt
- canceled qualified real property business debt
- principal residence indebtedness under terms of the Mortgage Debt Relief Act (2007 through 2020). This can also apply to debt that is discharged in 2021 provided that there was a written agreement entered into in 2020. This was further extended through 2025 by the Consolidated Appropriations Act in December of 2020.
If you claim an exclusion, you can’t claim tax credits or capital losses or otherwise improve your tax situation using the excluded property.
TurboTax Tip:
If your debts exceed the value of all of your assets, you are deemed insolvent. If you’re insolvent immediately before the cancellation of the debt, you can exclude canceled debt from income up to the amount that you are insolvent.
The Mortgage Debt Relief Act of 2007
Applying only to your principal residence, the Mortgage Debt Relief Act excluded as income any debt discharge up to $2 million. Provisions of the Act applied to most homeowners, and it included partial debt relief gained through mortgage restructuring as well as full foreclosure. Refinancing was also allowed, but only up to the amount of principal balance of the original mortgage.
The Act also covered loans and subsequent debt forgiveness for amounts borrowed to substantially improve a principal residence. You cannot use provisions of the Act for other canceled debts, and the relieved debt must be secured by the principal residence property. The Act covered debt forgiven within the calendar years of 2007 through 2020. This can also apply to debt that is discharged in 2021 provided that there was a written agreement entered into in 2020.
Extension of the Mortgage Debt Relief Act
The Act initially covered a three-year period between 2007 and 2010, but was extended five times, to 2012, 2013, 2014, 2016, 2017, 2019 and then to 2020. This can also apply to debt that is discharged in 2021 provided that there was a written agreement entered into in 2020.
The Consolidated Appropriations Act (CAA) was signed into law on December 27, 2020 as a stimulus measure to provide relief to those affected by the pandemic. The CAA extends the exclusion of cancelled qualified mortgage debt from income for tax years 2021 through 2025. However, the maximum amount of excluded forgiven debt is limited to $750,000.
Another way around the tax bite
If you’re not covered by the special tax break for principal residences described above, there are two very important exceptions to the “cancelled debt = taxable income” rule.
The cancelled debt is not income, even if you receive a Form 1099-C:
- If you received the cancelled debt due to bankruptcy filing.
- To the extent you are insolvent immediately before the cancellation of the debt.
Insolvency means your debts exceed the value of all your assets. You can exclude cancelled debt from income up to the amount that you are insolvent.
- For example, if you had assets of $80,000 and debt of $100,000, you are considered to insolvent by $20,000.
- If you had $30,000 in debt cancelled at this time of insolvency, you would have to include only $10,000 ($30,000 minus $20,000) in your income.
Cancelled debt can be a challenging tax situation especially during hard financial times. TurboTax will guide you through the cancelled debt maze, including the new legislation, and help minimize the pain from in these tough situations.
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