From IRS Tax Advocate Program

If you borrow money and the lender later cancels or forgives that debt, you may have to include the canceled amount in income for tax purposes, depending on the circumstances. For example, you borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.

A federal government agency or lender who cancels or forgives a debt you owe of $600 or more is required to file with the IRS Form 1099-C, Cancellation of Debt, which shows amounts and other information relating to the cancellation. The lender is required to provide you with a copy of Form 1099-C.

Is cancellation of debt income always taxable?
Cancellation of debt income is not always taxable. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
• Bankruptcy: Debts discharged in a Title 11 bankruptcy case are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
• Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
  If all or part of the canceled debt qualifies to be excluded under one of the exclusions listed above, the amount excluded from income must be reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). The Form 982 must be attached to your tax return. The remaining canceled debt, if any, must be included as income on your tax return.

Where do I report taxable cancellation of debt income?
If the debt is a nonbusiness debt, report the amount of the canceled debt on Form 1040, line 21. If it is a business debt, report the amount on Schedule C (Form 1040) or Schedule C-EZ (Form 1040). If the debt is a farm debt and you are a farmer, the amount should be reported on Schedule F (Form 1040), Profit or Loss from Farming.

Contact IRS directly at  1-800-829-1040, or visit  www.irs.gov to locate the closest IRS Taxpayer Assistance Center for more information.

Kerr & Kerr is also here to help you.  Call us at 305-387-5880 or visit us at kerrkerr.com.