Cancelled Debt & Form 1099-C

When a creditor cancels, forgives, or discharges a debt you owe for less than the full amount, the IRS generally treats the cancelled amount as taxable ordinary income. This rule under IRC Section 61(a)(11) surprises many taxpayers who receive unexpected tax bills after settling debts. However, important exclusions under IRC Section 108 can provide relief.

---

The General Rule: Cancelled Debt Is Taxable

Under IRC Section 61(a)(11), gross income includes income from discharge of indebtedness. If you owed $50,000 and the creditor accepts $35,000 as payment in full, you have $15,000 of cancellation of debt (COD) income.

Form 1099-C: Cancellation of Debt

Creditors must file Form 1099-C when they cancel a debt of $600 or more. Key boxes include:

Important: Even if you do not receive a Form 1099-C, you must still report COD income unless an exclusion applies. The $600 reporting threshold does not change the taxability of smaller amounts.

Identifiable Events (Box 6 Codes)

Form 1099-C reports the reason for debt cancellation:

---

Exclusions from Cancellation of Debt Income

IRC Section 108 provides six major exclusions that allow taxpayers to exclude COD income from gross income. These exclusions apply in a specific priority order.

Exclusions Comparison Table

Priority of Exclusions

1. Bankruptcy exclusion takes precedence over all others
2. Insolvency exclusion takes precedence over qualified farm and qualified real property business debt
3. Taxpayers may choose between insolvency and qualified farm/real property business debt if both apply

---

Bankruptcy Exclusion (Title 11)

Debt discharged in a Title 11 bankruptcy case is completely excluded from gross income. This is the broadest exclusion because:

• There is no dollar limit on the exclusion
• The discharge must occur under court order in the bankruptcy case
• The exclusion applies regardless of the taxpayer's solvency status

Key requirement: The bankruptcy must be a Title 11 case (Chapter 7, 11, 12, or 13) filed in federal bankruptcy court. State court proceedings or informal settlements do not qualify.

Tax attribute reduction: After claiming the bankruptcy exclusion, you must reduce tax attributes by the excluded amount (see Part II of Form 982).

---

Insolvency Exclusion

The insolvency exclusion allows taxpayers to exclude COD income to the extent they are insolvent immediately before the cancellation.

Calculating Insolvency

You are insolvent when total liabilities exceed the fair market value of total assets.

What Counts as Assets?

The IRS requires you to include all assets in the calculation, even exempt assets:

• Include: Bank accounts, investments, retirement accounts (IRA, 401(k)), real estate equity, vehicles, personal property, life insurance cash value
• Include exempt property: Assets protected from creditors under state law are still counted
• Use FMV: Not cost basis—fair market value on the date immediately before cancellation

Insolvency Example

In this example, only $20,000 of the $30,000 cancelled debt is excludable because the taxpayer was insolvent by $20,000. The remaining $10,000 must be reported as ordinary income on Schedule 1 (Form 1040).

Form 982 reporting: Check Line 1b and enter the excluded amount ($20,000) on Line 2.

---

Qualified Principal Residence Indebtedness (QPRI)

The Mortgage Forgiveness Debt Relief Act allows taxpayers to exclude cancelled debt on their principal residence. This provision has been extended through December 31, 2025.

Requirements for QPRI Exclusion

What Qualifies as Acquisition Debt?

• Original purchase mortgage
• Refinance to the extent of original acquisition debt balance
• Debt to substantially improve the residence

What Does NOT Qualify?

• Home equity debt used for other purposes (vacation, credit cards, car)
• Cash-out refinance amounts above original acquisition debt
• Debt on rental property or second homes
• Debt exceeding $750,000 ($375,000 MFS)

Basis reduction: After claiming the QPRI exclusion, reduce the basis of your principal residence (but not below zero).

---

Qualified Farm Indebtedness

Taxpayers engaged in farming may exclude COD income from qualified farm debt.

Requirements

• 50% or more of gross receipts from farming in the 3 preceding tax years
• Debt incurred directly in connection with the farming business
• Creditor must be a qualified person (actively engaged in lending, not related party)

Exclusion Limit

The exclusion cannot exceed the sum of:

1. Tax attributes (NOL, credits, etc.), PLUS
2. Aggregate adjusted basis of qualified property

---

Qualified Real Property Business Indebtedness (QRPBI)

Non-C corporation taxpayers can exclude COD income from business real property debt.

Requirements

• Debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property
• Property must be used in a trade or business
• Must be secured by the real property
• Not available to C corporations

Exclusion Limits

The QRPBI exclusion is limited to the lesser of:

1. Amount by which debt exceeds FMV of the property, OR
2. Aggregate adjusted basis of depreciable real property held immediately before discharge

Key difference: This exclusion reduces only the basis of depreciable real property—not other tax attributes.

---

Student Loan Discharge (Death or Disability)

Student loan debt discharged due to the borrower's death or total and permanent disability is permanently excluded from income.

Qualifying Loans

• Federal student loans under IRC Section 108(f)(2)
• Private education loans under the Consumer Credit Protection Act

Requirements

• Discharge must be due to death or total/permanent disability
• Taxpayer must include SSN on tax return (and spouse's SSN if married)

Note: This is a permanent exclusion that does not expire. Through 2025, most other student loan forgiveness is also temporarily excluded under the American Rescue Plan Act.

---

Tax Attribute Reduction (Form 982, Part II)

When you exclude COD income, you must reduce tax attributes to prevent a double tax benefit. This reduction applies to exclusions for bankruptcy, insolvency, qualified farm debt, and (for basis only) QRPBI.

Order of Attribute Reduction

Reduce attributes in this order unless you elect to reduce basis first:

Election to Reduce Basis First

You may elect to reduce the basis of depreciable property before reducing other attributes. This election is made by checking the appropriate box on Form 982, Line 5.

Strategy: Electing to reduce basis first may preserve valuable NOLs for future use.

---

Recourse vs. Non-Recourse Debt

The distinction between recourse and non-recourse debt affects how cancelled debt is treated:

Recourse Debt

The creditor can pursue the borrower personally for the full debt beyond just the collateral.

Tax treatment when forgiven:

• Bifurcated transaction if property is surrendered
• Amount realized on disposition = FMV of property
• COD income = Debt cancelled minus FMV of property
• Result: Capital gain/loss on property PLUS ordinary COD income

Non-Recourse Debt

The creditor can only look to the collateral (property) to satisfy the debt—not the borrower's other assets.

Tax treatment when property is surrendered:

• Amount realized = Full debt amount (not FMV)
• No COD income because the full debt is treated as sales proceeds
• Result: Capital gain (or loss) only—no ordinary income

Comparison Example

Exam tip: Non-recourse debt produces capital gain; recourse debt produces ordinary COD income. The character of income affects which deductions and exclusions may apply.

---

Filing Requirements and Forms

Form 982: Reduction of Tax Attributes

File Form 982 with your tax return to:

1. Claim an exclusion from COD income (Part I)
2. Report reduction of tax attributes (Part II)

Even if your COD income is fully excluded, you must file Form 982 to notify the IRS.

Where to Report COD Income

If COD income is not excluded, report it on:

• Schedule 1 (Form 1040), Line 8c — Cancellation of debt

Keeping Records

Maintain documentation including:

• Form 1099-C received
• Insolvency worksheet (assets and liabilities)
• Mortgage documents proving acquisition debt status
• Bankruptcy discharge orders