In the United States, the cancellation of indebtedness for individual income tax payers is generally considered a taxable event, meaning the taxpayers must include the amount of cancelled debt when calculating gross income. There are exceptions to this rule, however. In addition, for taxpayers who have inadvertently excluded cancellation of debt income from their income tax returns, the Internal Revenue Service (IRS) statute of limitations may prevent the IRS from collecting the related tax.
The typical mechanism the IRS uses to identify and report cancellation of indebtedness income is Form 1099-C, Cancellation of Debt. This form requires certain business and government agencies that cancel individual income tax-payer indebtedness of more than $600 to report the amount of income related to the cancellation to both the taxpayer and to the IRS. Not all business entities or individuals are required to use this form, however. Situations involving cancellation of personal indebtedness, for example, which may result in a taxable event, does not involve the use of this form.
Not all cancellation of debt creates a taxable event and is reportable as part of a taxpayer's gross income. The most typical exemptions involve bankruptcies and insolvency. A formal discharge of indebtedness through a Chapter 11 bankruptcy through the U.S. Bankruptcy Court system does not result in taxable cancellation of debt income. In addition, there is a more complicated exception for insolvent taxpayers and real property business or farm indebtedness. Finally, certain student loan debt assumed or paid by businesses may qualify as exempt.
Mortgage Debt Relief Act of 2007
The Mortgage Debt Relief Act of 2007 provides a further exception to the realization of taxable cancellation of debt income. This act provides that up to $2 million of debt on a taxpayer's principal residence may be generally forgiven without the taxpayer needing to recognize taxable income. The act applies to debt cancelled between 2007 and 2012. It generally does not apply to debt incurred related to your primary residence that was not used to purchase or improve the property.
Statute of Limitations
Many taxpayers are unaware of the Internal Revenue Code's requirement that cancellation of indebtedness income is included in gross income. As a result, many taxpayers inadvertently exclude these amounts from their individual income tax returns. Typically, the IRS has three years in which to assess the taxpayer with an amount due. The period is extended to six years when the taxpayer omits gross income in excess of 25 percent of the gross income reported on the tax return.
Statute of Limitations - Warning
The three- or six-year period covered by the statute of limitations begins on the date the taxpayer files his individual income tax return. In instances where the taxpayer subsequently amends his income tax return, the three- or six-year period is typically reset, or starts again at zero.
In addition, the statute of limitations applies only to returns in which the omission of income is inadvertent. There is no statute of limitations for fraudulent omissions.
- Internal Revenue Service: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
- Internal Revenue Service: General Instructions for Certain Information Returns
- Alvin Brown and Associates: Time Limitations to Prevent the IRS from Collecting Tax and Levy
- Forbes: Ten Things to Know About Cancellation of Debt Income
- Internal Revenue Service: Form 1099-C, Cancellation of Debt