If your debt has gotten so large you can no longer afford to pay it, negotiating a debt cancellation with your lender might be just what you need in order to get by. Unfortunately, your next challenge might be a huge tax bill. In most situations, if you receive a Form 1099-C from a lender, you'll have to report the amount on that form to the Internal Revenue Service as taxable income. Certain exceptions do apply.
How the IRS classifies cancelled debt
You might consider it unfair that a debt you successfully cancel or negotiate away comes back to haunt you as taxable income. However, the IRS classifies cancelled debt as income because you received a payment you didn't return.
When you first borrow money, you don't have to pay tax on the money you receive because you are bound by a contract to pay it back. Once that contract no longer exists, the money is yours to do with as you please. Since you essentially received income for free, the cancellation of your obligation to pay it back makes it taxable.
According to the IRS, nearly any debt you owe that is canceled, forgiven or discharged becomes taxable income to you. You'll receive a Form 1099-C, "Cancellation of Debt," from the lender that forgave the debt. Common examples of when you might receive a Form 1099-C include repossession, foreclosure, return of property to a lender, abandonment of property, or the modification of a loan on your principal residence.
Mortgage forgiveness debt relief act
Due to the magnitude of the concurrent real estate market collapse, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007. For calendar years 2007 through 2014, you could exclude up to $2 million in forgiven mortgage debt if you were married and filing jointly -- up to $1 million for other filing statuses. This exclusion applied to mortgage debt forgiven through a mortgage restructuring or in connection with a foreclosure.
Bankruptcy and insolvency
Even if you receive a Form 1099-C from a lender, you still may be able to avoid taxation on the forgiveness of a debt. If your debt was discharged in a Title 11 bankruptcy proceeding, such as a Chapter 7 or Chapter 13 case, you're not responsible for taxes on that debt.
If you can demonstrate to the IRS that you were insolvent at the time the debt was cancelled, you can similarly avoid taxes on that debt. Certain other types of debt, including qualified farm indebtedness and qualified real property business indebtedness, can also avoid taxation in the event of cancellation.