Tax Treatment of Debt Forgiveness: Watch Out for Tax Bills Delivered COD
Kirsch CPA Group
Jan 18, 2023
Debtors typically experience a feeling of relief when a creditor agrees to forgive their debt. But that feeling often is replaced by shock and confusion when they learn they owe taxes on so-called “cancellation of debt” (COD) income. Read on to learn the tax rules for COD income and how they might affect your tax situation.
General Rule
The IRS considers your debt canceled if it’s forgiven or discharged for less than the full amount you owe. Debt cancellation can occur in a number of circumstances. For example, it’s considered cancellation if a creditor gives up on collecting a debt you’re obligated to pay. Cancellation also occurs when there’s a foreclosure, repossession, voluntary transfer of property to the lender, abandonment of the property or a mortgage modification.
The debt you don’t end up on the hook for is treated as income for tax purposes. You generally must report it on your personal tax return. If it’s a business debt, you should report it on the applicable tax schedule. The creditor may send you a Form 1099-C, “Cancellation of Debt,” but you must report the canceled amount on your tax return for the year the cancellation occurred regardless of whether you receive such a form.
Recourse vs. Nonrecourse Debt
If your debt was secured by property and the creditor takes the property in full or partial satisfaction of your debt, the IRS treats the transaction as a sale of the property to the creditor. The resulting tax treatment will turn on whether the debt was recourse or nonrecourse.
Debt for which you’re personally liable is recourse debt. If you default and the surrender of the property doesn’t fully satisfy the debt, the creditor can go after you for the balance. You’re not personally liable for nonrecourse debt, though, so the lender is entitled only to the property if you default. If you receive a Form 1099-C from a creditor, it should indicate if you were personally liable for the debt.
With a recourse debt, the amount realized on the “sale” is the fair market value (FMV) of the property you surrender. Your taxable ordinary income from the cancellation is the amount by which the debt exceeds the FMV (assuming none of the exceptions or exclusions below applies). The difference between the FMV and your adjusted tax basis (usually your cost) will be gain or loss on the disposition of the property.
How It Works
For example, suppose you bought a vehicle for business use for $20,000, making a $2,000 down payment and signing a recourse note for the balance. You pay down an additional $4,000 on the debt before you’re unable to make any more payments, leaving outstanding debt of $14,000 ($20,000 minus $2,000 down payment minus $4,000 debt payments). The dealer repossesses the vehicle, whose FMV has dropped to $11,000, and cancels the remaining $3,000 of debt ($14,000 minus $11,000). The $3,000 is COD income. You’ll also have a $9,000 loss ($11,000 FMV minus $20,000 basis).
With nonrecourse debt, you realize the entire amount of the debt plus the amount of cash and the FMV of any property you received. You don’t have any ordinary income from the cancellation, though. In the example above, if the note was nonrecourse, you’d have a loss of $6,000 upon repossession ($14,000 realized on the remaining debt minus $20,000 basis).
Exceptions and Exclusions
The following amounts aren’t treated as COD income:
- Amounts canceled as gifts, bequests, devises or inheritances,
- Certain qualified student loans canceled due to meeting work requirements,
- Certain student loan repayment assistance programs,
- Certain student loan discharges after December 31, 2020, and before January 1, 2026,
- Amounts of canceled debt that would be tax-deductible if you, as a cash-basis taxpayer, paid it,
- A qualified purchase price reduction given by the seller of property to you as the buyer, and
- Any amounts discharged from certain federal, private or educational student loans.
By contrast, the following amounts constitute COD income — but are excluded from gross income for tax purposes:
- Debt canceled in a federal bankruptcy,
- Debt canceled to the extent you were insolvent at the time of cancellation,
- Canceled qualified farm debt,
- Canceled qualified real property business debt, and
- Canceled qualified principal residence debt that’s discharged subject to an arrangement entered into and evidenced in writing before January 1, 2026 (up to $750,000, or $375,000 if married filing separately).
The exclusions aren’t as straightforward from a tax perspective as they might seem. If you excluded canceled debt, you generally must reduce certain tax attributes (including certain credits and carryovers, losses and carryovers, and basis) by the amount excluded. The qualified principal residence debt exclusion, however, requires only the reduction of your basis in the residence.
Tread Carefully
It’s wise to consult with Kirsch CPA Group before you enter any debt forgiveness or relief arrangements. Understanding the tax implications in the context of your overall circumstances can reduce the odds of an unwelcome surprise.
Contact us to learn more about the impact of debt forgiveness on taxes
© Copyright 2023. All rights reserved.
About The Author
Kirsch CPA Group is a full service CPA and business advisory firm helping businesses and organizations with accounting,…
Tags
Sign Up for Email Updates
Related Articles
Manufacturers: Be Aware of These 3 Business Tax Provisions Currently in Limbo
- 01-18-23
- Kirsch CPA Group
The Tax Deductible Mileage Rate for Business Driving Increases for 2023
- 01-04-23
- Kirsch CPA Group
Succession Planning Considerations for Construction Business Owners
- 12-14-22
- Kirsch CPA Group
Prevent Fraud at Your Construction Company With a Holistic Approach
- 11-30-22
- Kirsch CPA Group
Manufacturers Must Act Now to Maximize Depreciation-Related Tax Breaks for 2022
- 11-09-22
- Kirsch CPA Group
It’s Time for Businesses to Rethink Their Working Capital Practices
- 11-09-22
- Kirsch CPA Group
Social Security Wage Base and Earnings Test Amounts Increase in 2023
- 10-27-22
- Kirsch CPA Group
New Law Enhances Payroll Tax Break for Small Manufacturers’ Research Expenses
- 10-13-22
- Kirsch CPA Group
How Buy-Sell Agreements Factor into Business Owners’ Estate Plans
- 09-14-22
- Kirsch CPA Group
SALT Cap Workaround Law Could Save Ohio Business Owners Over $100 Million
- 08-31-22
- Kirsch CPA Group
How Manufacturing Companies Can Benefit from the Section 179 Expensing Deduction
- 08-04-22
- Kirsch CPA Group
Could the Work Opportunity Tax Credit Help Your Construction Company?
- 06-23-22
- Kirsch CPA Group
Good News: IRS Boosts Standard Mileage Rates for Second Half of 2022
- 06-23-22
- Kirsch CPA Group
Education Benefits Can Help You Recruit and Retain Smart Employees
- 05-26-22
- Kirsch CPA Group
Ensure Your Construction Accounting System Has the Right Features
- 05-12-22
- Kirsch CPA Group
John Kirsch Named to Greater Butler and Warren Counties Business Hall of Fame
- 03-25-22
- Diane Glover
Manufacturers Need to Act Soon to Take Advantage of 100% First-year Bonus Depreciation
- 03-17-22
- Kirsch CPA Group
Commission Fraud: Salespeople Getting Paid More Than They’ve Earned
- 02-04-22
- Kirsch CPA Group
Consider a New Approach to Meeting Your Business Real Estate Need
- 09-17-21
- Kirsch CPA Group
Beware: Teleworking Arrangements May Cause State Tax Withholding Issues
- 08-18-21
- Kirsch CPA Group
5 Common Construction Accounting Risks — and How to Address Them
- 07-07-21
- Kirsch CPA Group
Supreme Court Finds No Standing to Challenge a Provision of the ACA
- 06-24-21
- Kirsch CPA Group
Labor Shortage: Unlock Solutions by Evaluating Your Employment Value Proposition
- 06-09-21
- Kirsch CPA Group
Material Participation Standard is the Key to Unlocking LLC Tax Losses
- 05-27-21
- Kirsch CPA Group
Know Your Legal Obligations Under the Americans with Disabilities Act
- 05-13-21
- Kirsch CPA Group
PPP Loan Not Forgiven? There’s a Safe Harbor for Deducting Expenses
- 12-03-20
- Kirsch CPA Group
What You Need to Know About the Deferral of Payroll Tax Obligations
- 09-15-20
- Kirsch CPA Group
PPP Loan Forgiveness – Significant Borrower Friendly Changes on the Horizon
- 06-04-20
- John Kirsch
Tax Filing Deadline Remains April 15 – Payment Due Extended to July 15
- 03-19-20
- John Kirsch
Prepare to Receive a Social Security Administration No-Match Letter
- 10-15-19
- Kirsch CPA Group
IRS Announces Changes for Personal Use of Employer-Provided Vehicles
- 06-10-19
- Diane Glover
Watch Out for these Tax Issues When Planning for Your Business in 2018
- 06-26-18
- Diane Glover
What Image Does Your Organization Present to Large Contributors?
- 03-15-18
- Kirsch CPA Group
8 strategies to help you adapt to economic down turn without layoffs
- 02-24-18
- Diane Glover
Remember To Take Required Minimum Distributions at Age 70 1/2 Or Face Penalties
- 02-17-17
- Sue Schloemer
Time is Money: Don’t Spend Valuable Time Inputting Data into QuickBooks
- 06-18-22
- Diane Glover