Normally, when a creditor cancels your debt, as in the foregiveness of a mortgage if your house is underwater, you must pay tax on the difference between the loan amount and the fair market value of the house. This is referred to a "cancellation of debt" income (COD Income) and you are normally taxed on it by the IRS. However, there are several exceptions which allow you to exclude this from income and not be taxed on the amount. Here is how to calculate and exclude the cancellation of debt income.
What happens when you receive a 1099-C
Normally, you will receive a 1099-C from a financial institution if they cancel more than $600 in debt you owe. If it is not otherwise exclusible from income, you must include it on your tax return as income in the "other income" box of your 1040. The bank or other financial institution does not know if you meet one of the exceptions or exclusions, they just simply send out the 1099-C showing the cancellation of debt income because they are obligated to send you this form. It is up to you to figure out whether or not you meet one of the exceptions.
How to calculate how much cancellation of debt Income you have
Most people's cancellation of debt income comes from a house that was foreclosed on or repossessed by the bank. The calculation of this debt is based on what type of loan you have with the bank, whether it is recourse or non-recourse.
A recourse loan is one in which the bank can go after you personally if you default on a payment. Recourse loans cancellation of debt is treated in two parts:
1) Sale -- First, you treat the foreclosure/repossession as a sale, taking into account the fair market value of the foreclosure price or appraised value of the property before the short sale/deed in lieu of foreclosure. Then subtract from that amount your adjusted basis in the property, which is usually what you purchased the house for. This is your gain or loss on the the "sale" of the property. Depending on whether or not your house is a capital asset, it can be capital gains or ordinary income
2) Cancellation of debt -- Then, the amount of the cancellation of debt is treated separately. This is the loan amount minus the fair market value the property sold for. This amount is ordinary income, unless an exclusion applies.
A non-recourse loan is a loan which is secured against a piece of collateral, usually the property. If you default on the loan, the bank is only able to take the proceeds of the property, and not your personal assets to satisfy the loan proceeds.
1) Sale/COD -- A non-recourse loan is treated in only one step instead of two. The amount of cancellation of debt income is equal to a) The full amount of the loan minus b) Your adjusted basis in the property, usually what you bought the property for. If the house is a capital asset, if may be capital gains.
If you hold your loan with another person and the debt is canceled, you will both receive a 1099-C for the full amount of debt canceled. However, this does not mean that you both have to pay the full amount of cancellation of debt income. Instead, you should allocate the Cancellation of Debt income among you according to state law or according to how you share the interest deduction, depending on the circumstances.
Exceptions and Exclusions
Even if you receive a 1099-C, you may be able to exclude the amount of cancellation of debt income if you meet one of the exceptions or exclusions to cancellation of debt Income. You may find a full explanation of all of the exceptions and exclusion to cancellation of debt income in my guide here: