Column: Tax consequences of debt discharge income

Although the economic benefits of having a debt forgiven are obvious, many people are finding that there may be some unexpected tax consequences. If you have had (or are considering having) some or all of your debt cancelled or forgiven by your lender, you should be aware of the following tax rules and try to plan accordingly.

General Rule:

Discharged debt is normally includable as income on your tax return. However, there are several exceptions to this rule and numerous exclusions from gross income for certain types of forgiven debts.


If the cancellation of debt by a private lender, such as a relative or friend, is intended as a gift, there is no income. Likewise, a debt cancelled by a private lender's last will and testament triggers no income to the borrower.

There is also an exception for certain student loans. For example, doctors, nurses and teachers who agree to serve in rural or low-income areas in exchange for cancellation of their student loans won't have income from the cancellation if they meet certain conditions.

Also, keep in mind that there is no income from cancellation of a debt that was deductible. For example, if a lender cancels home mortgage interest that could have been claimed as an itemized deduction on Schedule A of Form 1040, there is no tax problem to contend with.

Price adjustment:

There is no income if an individual purchases property and the seller later reduces the price. Instead, the purchaser's basis – the yardstick used for measuring gain or loss when the property is sold – is reduced by the amount of the purchase-price adjustment.


In addition to the above exceptions, there are exclusions from the general rule of reporting canceled debt as income for:

•  discharge of debt through bankruptcy

•  discharge of debt of an insolvent taxpayer

•  discharge of “qualified farm debt”

•  discharge of “qualified real property business debt”

•  discharge of up to $2 million of “qualified principal residence debt”

These exclusions are complicated, and a detailed discussion of them is beyond the scope of this discussion. However, it is worth pointing out that the qualified principal residence debt exclusion applies where individuals restructure their acquisition debt on a principal residence, lose their principal residence in a foreclosure, or sell a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance). Also, the exclusions require certain tax attributes to be reduced and must be reported to the IRS on its Form 982.

Form 1099-C

By law, a taxpayer should receive a Form 1099-C (Cancellation of Debt) from a financial institution, credit union, or federal government agency that forgives a debt of $600 or more. The amount of the canceled debt is shown, as is any applicable forgiven interest included in the amount of canceled debt. As noted above, if the interest would otherwise be deductible, it does not have to be included in income.

An individual who disagrees with the amount shown on Form 1099-C should contact the lender in writing and ask for a corrected form. Even if the lender refuses, you may still have recourse if you can document the correct amount of canceled debt.

As with most financial decisions, it is important to discuss the options available to you with a trusted tax advisor. They will be able to help you properly report these transactions on your tax return, make sure you gain maximum advantage from any exception or exclusion that may apply, and guide you through various choices that may be available in your situation.

Jan Stockton is the founder of Stockton & Associates P.C., a CPA firm located in downtown Vancouver. She can be reached at 360-695-6511.