Cancellation of Debt

Cancellation of debt is a popular topic for the 2009 tax year. I am sure more then a few people will be receiving 1099-C, Cancellation of Debt, forms in the mail. These 1099-C forms are issued by lenders to report when they have discharged (forgiven) outstanding loan amounts owed by the taxpayers.

What taxpayers often fail to realize is that cancelled debt is required to be included as income on their tax return, unless a few specific exceptions apply. The most common exceptions are if the taxpayer discharges their debt through bankruptcy or can prove they are insolvent. Put simply, a taxpayer is insolvent when their debts exceed the fair market value of their assets. However, this can be a complex calculation and a tax professional should be involved in determining if the insolvency exemption is appropriate.

The good news is that the *IRS created a new exception that can prevent taxpayers from having to pick up cancellation of debt income if their home mortgage is forgiven. The Mortgage Forgiveness Debt Relief Act of 2007 created a new tax provision that allows any taxpayer who benefited from discharged indebtedness on their qualified personal residence to exclude that cancelled debt from being considered taxable income. Please note that this exclusion is only available for up to $2 million dollars of debt forgiveness ($1 million for those married filing separately); anything above $2 million of debt forgiveness will still be considered taxable income. Also, this exception is only available for mortgages forgiven from January 1, 2007 thru December 31, 2012.

Keep in mind this only applies to qualified personal residences. Also, the *IRS requires that taxpayers reduce the basis of their personal residence by the amount of debt forgiven, but you do not have to reduce basis below zero. Clearly, this is a complex area that most likely requires help of a tax professional, but it is important to know that an exclusion exists for those that may have received 1099-C’s relating to debt forgiven on their qualified personal residence mortgage.