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PostHeaderIcon Tax Issues on Cancellation of Indebtedness (COD) Income

Cancellation of indebtedness (COD) income has become a bigger issue in the past few years then I ever remember it being.  At its core, if you take on debt and that debt is subsequently forgiven, you should be taking the amount of debt into your tax return as income.  It seems harsh because usually debt is cancelled because of a hardship but the good news is, there a couple of different exclusions that mean when you get a 1099-A (Acquisition or Abandonment of Secured Property) or a 1099-C (Cancellation of Debt) you should be talking to a tax professional.  If you ignore it, the IRS will come back at you (I know because I’ve helped people fix this when they’ve gotten a notice) but you also don’t want to just take the full amount reported as income and pay the tax either.

The first major exclusion addresses the foreclosure crisis and was part of the Mortgage Debt Relief Act of 2007.  The provision basically says that if debt was forgiven on your purchase of a principal residence, you can exclude up to $2 million of COD income if the debt was forgiven between 2007 and 2012 (expiring soon).  In order to qualify as your personal residence you have to had lived there for two or more years out of the last five.  Also be careful because this usually includes just the amount on the original note.  If you refinanced at some point and pulled cash out, then that debt might not qualify (again, be sure to talk to a tax professional) so it’s not as easy as just ignoring anything related to your home.

The next major exclusion is a four parter detailed in Code Section 108.  The four exclusions are for

1)  a debt discharge in a bankruptcy action under Title 11 of the U.S. Code in which the taxpayer is under the jurisdiction of the court and the discharge is either granted by or is under a plan approved by the court.
2)  a discharge when the taxpayer is insolvent outside of bankruptcy
3)  a discharge of qualified farm indebtedness
4)  a discharge of qualified real property business indebtedness

Okay, take a breath.  The exclusion most people will fall under is number two.  The short explanation is, if you have a debt that’s cancelled and you’re insolvent (liabilities are less then assets and you get to take into account the debt that was forgiven), you can exclude the debt. It get’s tricky when you have multiple COD events (i.e., you have three credit cards and their forgiven at certain times) and in that event, as your liabilities come down, you might find yourself paying tax on some of the COD income.  And I’ll say it for a third time, but when you’re working in this arena, be sure to talk to a tax professional.

UPDATE – The provision that lets you excluded cancellation of indebtedness income on your personal residence was extended through the end of 2013.