Cancellation of Indebtedness Income and Insolvency

Most people in Rockland County are unlikely to be familiar with IRS Form 1099C or the term “cancellation of indebtedness income.” A Form 1099C is one of the many methods of reporting income that does not appear on a Form W-2 or a Form 1099MISC. The arrival of a Form 1099C can cause unexpected income tax headaches, but both bankruptcy and insolvency offer an escape.

When a creditor cancels a debt and sends a Form 1099C to the borrower and the IRS, the amount of the cancelled debt is considered ordinary income by the IRS. The reasoning is straightforward: Under ordinary circumstances, the borrower would be required to repay the debt, most often with after-tax income. If the lender cancels the debt, the borrower is relieved from the obligation to pay off the loan, and the amount of the cancelled debt thus becomes income to the borrower. The borrower must report the income shown on the Form 1099G to the IRS on Form 1040 and pay tax on the amount of the cancelled debt.

The Internal Revenue Code provides two escapes from this problem: bankruptcy and insolvency. A debt that is wholly or partially discharged in a Chapter 11 proceeding may be excluded from income to the extent of the discharged amount. The second escape route is insolvency: if the taxpayer is insolvent as of the date on which the lender cancelled the debt, the amount of the cancelled debt is also excludable from ordinary income. In such cases, “insolvency” has its ordinary meaning: an excess of liabilities over assets. If the net amount of liabilities does not exceed the amount of cancelled debt, the taxpayer must report and pay taxes on that portion of the cancelled debt that exceeds the taxpayer’s negative net worth.

Valuing assets, especially real estate, to determine if the exclusion is available may require expert legal or accounting assistance.