Exceptions to Cancellation of Debt Income
When a bank or other financial institution sends you a 1099-C, normally you have to report this amount on your tax return as income. However, there are many exceptions to this, outlined below.
Exceptions vs. Exclusions
Exceptions generally allow you to not include the amount at all, while exclusions will allow you to not include it, but you must reduce your tax attributes and fill out Form 982 and attach it with your 1040.
If the creditor gifts you the cancellation of debt, then it is not included into income.
If the debt would otherwise be deductible, such as a business expense, then the cancellation of debt will not be included into income.
If the debt is discharged pursuant to a bankruptcy court order, including Chapter 7, 11, and 13, then the cancellation of debt income can be excluded. However, you must file form 982 and reduce your tax attributes in order to take the exclusion
If you are insolvent, which is when your liabilities exceed your assets, immediately before the cancellation of debt income, you can exclude the income up to the amount of insolvency, but not above it. Therefore, the Bankruptcy exception is better than the insolvency exception if you have the choice.
Trade or Business Real Property Debt
If you trade in real property as part of your business, cancellation of debt from a property can be excluded.
Personal Residence Exclusion
If the home is your personal residence and you are foreclosed or have a short sale, you can exclude the cancellation of debt income, even if you do not file for bankruptcy or are insolvent. Generally the insolvency exclusion and the personal residence exclusion cannot be used together. You must file form 982 and reduce your tax attributes in order to take the exclusion.
How to Claim the Exclusion
In order to claim the exclusion, you must file Form 982 and attach it to your 1040. This form states how much of your cancellation of debt you are excluding, and also requires you to reduce your tax attributes as part of the exclusion. Tax attributes are things like your adjusted basis in the property and net operating losses, things that normally make your tax less. By reducing your tax attributes, you are being taxed more in the future, such as when you sell property or need to use a net operating loss.
Once you file Form 982, you can exclude the amount from being taxed on your 1040, and you will be well on your way to financial recovery.