Cancellation of Debt Income: How to Exclude from Gross Income

Last Updated Apr 5, 2011 9:30 AM EDT

If you negotiated with a creditor to settle a debt, then you've received a Form 1099-C Cancellation of Debt in the mail.
Creditors who forgive $600 or more are required to file Form 1099-C with the IRS. In 2010 it's expected that well over 3 million of these forms were sent by creditors to taxpayers and the IRS.
But here's the most important thing: if you received a Form 1099-C don't ignore it.
The lender that sent this to you is also sending a copy to the IRS. If you haven't listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or worse, an audit notice. This could end up costing you more in IRS interest and penalties.
According to the IRS, if a debt is cancelled or discharged, you must include the cancelled amount in your gross income, and pay taxes on that "phantom income." Suddenly you've got a tax problem.
But not so fast; the first thing you need to do is to figure out whether you quality for an exclusion or exception. If you don't get this right, you may pay more in taxes than you have to.
Here are the five types of Cancelled Debt that qualifies to be excluded from Gross Income:
  1. Cancellation of qualified principal residence indebtedness
  2. Debt cancelled in a Title 11 bankruptcy case.
  3. Debt cancelled due to insolvency
  4. Cancellation of qualified farm indebtedness
  5. Cancellation of qualified real property business indebtedness

One of the most overlooked exclusions is the debt cancelled due to insolvency. Here is how it works:

Say you negotiated to settle a credit card debt for $1000, where you originally owed $4,000. In this case you would receive a Form 1099-C with cancellation of debt income for $3,000, which is the amount of the debt discharged.

Let's assume that immediately before the discharge, the total value of your assets was $10,000 and the total amount of your debts was $15,000. In this case, your insolvency amount (the amount that your debts exceeded your assets) was $5,000. Since your insolvency was greater than the amount of the discharged debt, the cancellation of debt income is excluded from your gross income.

If this is your situation, you should read IRS Publication 4681, Canceled Debts, Insolvency. Also, attach a completed Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to your tax return.

My final word: seek advice from a qualified tax adviser for help on this issue.
  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.