Generally, income from debt cancellation is includible in gross income.1  The amount of income is the difference between the face value of the debt and the amount paid in satisfaction of the debt. Income is recognized in the year the debt cancellation occurs.2  Debt cancellation often occurs in a foreclosure sale.3  Cancellation of a large debt may result in taxability of Social Security benefits for a low-income taxpayer or loss of Earned Income Credits.4

Typically, debt cancellation income arises when a lender forgives a debt or a government entity waives an overpayment. Examples of potential debt cancellation income include reduction or forgiveness of personal credit card debt or loans,5  personal vehicle repossession, loan workout agreement or modification, mortgage foreclosure, quit claim or reconveyance to creditor, short sale, abandonment,6  Truth-in-Lending rescissions,7  and government waiver of overpayment by the government.8

• 1I.R.C. § 61(a)(12).
• 2Rood v. Comm’r, T.C. Memo 1996-248, aff’d, 122 F.3d 1078 (11th Cir. 1997); Jelle v. Comm’r, 116 T.C. 63 (2001).
• 3If local law provides a right to redeem a foreclosure sale, the sale is generally not final for tax purposes until the right to redeem expires. Great Plains Gasification Assocs. v. Comm’r, T.C. Memo 2006-276.
• 4Jelle, 116 T.C. at 70–71 (2001); Payne v. Comm’r, T.C. Memo 2008-66, n.3.
• 5The Tax Court has ruled that a reduced payment in settlement of a credit card debt constitutes debt cancellation income. Payne, T.C. Memo 2008-66 (purchase price adjustment exclusion denied); Plotinsky v. Comm’r, T.C. Memo 2008-244 (gift exclusion denied). Because no exclusions applied in Payne and Plotinsky, the write-off of the credit card debt was income to the taxpayer. See also Hill v. Comm’r, T.C. Memo 2009-101 (debt cancellation income where credit card judgment and debt written off after Ch. 13 bankruptcy dismissed).
• 6Frazier v. Comm’r, 111 T.C. 243 (1998).
• 7Schlifke v. Comm’r, T.C. Memo 1991-19.
• 8See, e.g., Waterhouse v. Comm’r, T.C. Memo 1994-467 (waiver of VA overpayment creates debt cancellation income). On the other hand, the IRS has privately ruled that the VA’s discharge of a veteran’s mortgage due to hardship was not taxable when the VA intended to reduce the veteran’s future benefits for the amount of the debt forgiveness. Priv. Ltr. Rul. 8839026 (June 29, 1988). Also, cancellation or waiver of an overpayment due to economic hardship should be excluded from income under the general welfare exclusion doctrine. See, e.g., Rev. Rul. 78-46, 1978-1 C.B. 22.

Debt cancellation income is income from the discharge of a debt. To evaluate the potential tax liability, first determine whether there was a “debt”.

If there is a dispute as to whether the taxpayer owed the debt, a compromise may not give rise to a discharge of a “debt.” Furthermore, a creditor may not need to report debts that are cancelled by operation of law.1  A settlement or “forgiveness” of a disputed or unenforceable debt does not result in income to the taxpayer.2  In Zarin v. Commissioner, no taxable income resulted from the settlement because the amount of the discharged debt was void ab initio due to the underlying illegality or fraud.3  Refinancing of a debt may also provide an exception to debt cancellation income.4

To win a Zarin argument, there must be evidence of a dispute as to the amount or enforceability of the debt. A settlement alone does not prove that a good faith dispute existed.5  The taxpayer has the burden of proof.6  If the taxpayer raises a reasonable dispute as to the amount of debt cancellation income on the Form 1099-C, the IRS must produce reasonable and probative information as to the amount of debt cancellation income and can’t rely on the Form 1099-C.7

To avoid tax consequences to the debtor, the settlement should include an agreement by the parties that the settlement agreement reflects settlement of disputed claims, that it does not represent a discharge of indebtedness for purposes of I.R.C. § 61(a)(12), and that the lender will not report the transaction as resulting in income to the debtor to any taxing authority. Lenders rarely agree to the last of these conditions, but that disagreement does not make the debt cancellation taxable income.

What are the tax consequences if the taxpayer successfully rescinds a transaction pursuant to the Truth-in-Lending Act or another consumer protection law? The IRS will argue that the difference between the loan principal and the amount paid by the taxpayer for rescission is debt cancellation income.8  The taxpayer can argue that there was no debt cancellation income under Zarin because the debt was disputed. This may be a successful argument, at least to the extent the taxpayer did not deduct interest in prior tax returns.

However, if the taxpayer took deductions for interest paid on this debt in prior tax years, the IRS will argue that recovery of the same is taxable income under the tax benefit rule. In Schlifke v. Commissioner, the Tax Court ruled that there was income from a rescission under the tax benefit rule to the extent that the taxpayer had taken deductions for interest on the rescinded mortgage.9

• 1See, e.g., IRS Chief Counsel Adv. Mem. 201112008 (Mar. 11, 2011) (principal reduction in negotiated settlement of unfair lending practices case); IRS Priv. Ltr. Rul. 2008-02-012 (Jan. 11, 2008).
• 2See, e.g., Zarin v. Comm’r, 916 F.2d 110, 115 (3d Cir. 1990).
• 3Id.; see also Estate of Smith v. Comm’r, 198 F.3d 515 (5th Cir. 1999) (unliquidated claim for contribution or restitution is not a “debt” that creates debt cancellation income).
• 4See Zappo v. Comm’r, 81 T.C. 77, 85–86 (1983).
• 5McCormick v. Comm’r, T.C. Memo 2009-239.
• 6Rood v. Comm’r, T.C. Memo 1996-248, aff’d, 122 F.3d 1078 (11th Cir. 1997).
• 7McCormick, T.C. Memo 2009-239.
• 8See Schlifke v. Comm’r, T.C. Memo 1991-19.
• 9Id.

A debt is discharged when it is clear that the debt will never have to be paid.1  Recourse debt is not discharged to the extent that there is a deficiency judgment or an unpaid deficiency that survives the foreclosure judgment.2  In some cases, the debt may not be discharged until the statute of limitations has expired.3  The applicable statute of limitations may be a complex issue.4  A creditor who sells credit card debt to a “debt buyer” may write off the debt and issue a Form 1099-C. However, in such cases, the debt is not discharged because the debt buyer usually continues to try and collect the debt. The tax attorney can provide copies of the new collection notices or other attempts at collection to prove that no discharge has occurred.

• 1Friedman v. Comm’r, 216 F.3d 537 (6th Cir. 2000); Cozzi v. Comm’r, 88 T.C. 435 (1987).
• 2See, e.g., Aizawa v. Comm’r, 99 T.C. 197 (1992), aff’d, 29 F.3d 630 (9th Cir. 1994); Webb v. Comm’r, T.C. Memo 1995-486.
• 3See Coburn v. Comm’r, T.C. Memo 2005-283 (abandonment of collateral on recourse liability, alone, did not extinguish underlying liability).
• 4See, e.g., Portfolio Recovery Assocs., LLC v. King, 927 N.E.2d 1059 (N.Y. 2010).

Creditors defined as “applicable entities” by I.R.C. § 6050P(c)(2) are required to issue a Form 1099-C reporting debt cancellation income to the IRS when they reduce a debt by at least $600. The duty to issue a Form 1099-C is triggered when there is a discharge of debt, which is deemed to occur when there has been an “identifiable event” as defined in 26 C.F.R. § 1.6050P(b)(2)(I). The IRS will argue that a discharge of debt occurred when the “identifiable event” occurred. But the IRS may be wrong. In some cases, the “identifiable event” may not constitute a discharge of the debt for determining when or whether debt cancellation resulted in income.

A Form 1099-C does not establish that a debt was discharged or the date of discharge.1  A Form 1099-C is not dispositive. If the taxpayer asserts a reasonable dispute with respect to reported income, I.R.C. § 6201(d) may shift the burden of production to the IRS, requiring it to produce reasonable and probative evidence in addition to the Form 1099-C.2  Unjustified reliance on Forms 1099-C by the IRS has led to attorney fee awards for taxpayers.3

The issuance of Forms 1099-C has skyrocketed in recent years. In 2005, debt buyers were, for the first time, required to issue Forms 1099-C.4  Most buyers of credit card debt have no idea or records of the balance due by the borrower before the original creditor charged off the debt. This ignorance produces inaccurate Form 1099-C reports of debt cancellation income. Often, debt buyers don’t know where the debtors live. So, many taxpayers never receive their Forms 1099-C.

Many low-income taxpayers don’t understand Forms 1009-C or their potential tax liability. A taxpayer should review Form 1099-C (or Form 1099-A) for accuracy and request correction by the lender/creditor if inaccurate. If the debt was transferred to a debt buyer, it is likely that the discharged debt is wrong if reported by the debt buyer. IRS Publication 4681 explains how to read Forms 1099-A and C. A taxpayer who erroneously paid taxes on cancellation of debt income may be able to amend the tax return to claim a refund.

• 1Sims v. Comm’r, T.C. Summ. Op. 2002-76.
• 2McCormick v. Comm’r, T.C. Memo 2009-239; cf. Portillo v. Comm’r, 932 F.2d 1128 (5th Cir. 1991).
• 3See, e.g., Owens v. Comm’r, 67 F. App’x 253 (5th Cir. 2003).
• 4Unfortunately, debt buyers are now “applicable entities” and are required to report debt cancellation. See Debt Buyers’ Ass’n v. Snow, 481 F. Supp. 2d 1 (D.D.C. 2006).