Is Cancelled Debt Taxable?

If you have managed to absolve yourself of certain debts, or if you had an asset reacquired by the lender, you may receive in the mail a form 1099-C, Cancellation of Debt.

What is cancellation of debt?

If you borrow money from a lender, as in the case of unsecured consumer credit card debt, but then fail to make payment and the debt ultimately is written-off or canceled, then the amount that was canceled may become taxable to you.

This occurs as well if a lender takes back their collateral because you defaulted on loan, such as a mortgage or vehicle loan. Once the bank reacquires the asset, they attempt to re-sell it or auction it so that they can recoup the outstanding amount owed on the loan. If they take a loss, then the amount still owed may become taxable to you.

A bankruptcy often triggers these debt cancellations. When debts are discharged through bankruptcy, especially unsecured debt , the lender receives little to nothing in terms or repayment. Although bankruptcy law allows for certain debts to be pardoned, depending on the terms and chapter you filed for protection under, the tax may still have to be paid.

Why is debt cancellation even considered taxable?

When the money was borrowed, you did not have to include any of it as income because you had full intention to repay these funds. Once the obligation is forgiven, or canceled, you now have the responsibility to account for the tax on those transactions. It's considered "income" to you because you had use of the money, did not repay it, and the lender was forced to take a loss.

Think of it in these terms: It's as if the lender gave you the money in order to pay the amount off.

Is debt cancellation always taxable?

Not necessarily. There are exceptions, the most common being foreclosed homes that fall under safeguard of the Mortgage Debt Relief Act of 2007.

According to the IRS, the Relief Act of 2007 "generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring , as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief."

This provision remains in play up through calendar year 2012. If the loan on a taxpayer's residence was canceled, debts up to $2 million may be eligible for this exclusion. This amount applies to couples filing jointly only. Single individuals or those filing separately from their spouse can exclude up to $1 million.

Some cancellations of debt do not have to be reported as income.

Certain student loans can be excluded if the person who received the loan worked for a period of time in their profession. Chapter 11 bankruptcy cases are excluded as well.

Additionally, if you are considered insolvent prior to the debt being forgiven, you can exclude the amount from your taxable income . The IRS says that if the total of all your liabilities was more than the fair market value of all assets immediately before the debt cancellation(s), you are insolvent.

For more information on debt cancellations, as well as a worksheet that is used to determine if you are considered insolvent, see IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

More from this Contributor:
How does filing bankruptcy affect IRS debt?
10 things you didn't know about an Offer in Compromise
What is the IRS Collection Due Process Appeal?