Cancellation of indebtedness occurs when creditors forgive debt.

This situation commonly arises when credit card companies settle debts and accept less than what the debtor owes. What most consumers do not know is that there are tax consequences for cancelled or forgiven debt. This is because the United States Internal Revenue Service considers canceled or forgiven debt as income. United States law and the IRS requires that creditors who agree to accept at least $600 less than the original balance owed by a debtor, to file Form 1099-C and to send debtors notices as well. The debtor must report the portion of the cancelled or forgiven debt as “income” on their income tax returns.

Although there are some exceptions that the debtor can claim to prevent cancelled debt from being taxed, most of these are taxable as income.

One such exclusion is that the IRS does not tax debts discharged under the Bankruptcy Code as income. Please consider the following circumstances:

Discharge of debts from bankruptcy is not taxable.

This is one of the biggest advantages of a bankruptcy over debt settlement or negotiation. It is the broadest exclusion of cancellation of indebtedness income. It also permits the debtor to take advantage of the exemptions under federal or state law.

Cancellation of indebtedness from the foreclosure of a primary residence is not taxable.

The Mortgage Forgiveness Debt Relief Act of 2007 made the cancellation of indebtedness on your primary residence non-taxable. Although the Act was set to expire on December 31, 2012, President Obama extended its deadline to December 31, 2013 by signing The American Taxpayer Relief Act. This only applies to debts that you incur for the purpose of acquiring, constructing, or substantially improving the property. This includes debts incurred in refinancing such a debt. However, a second mortgage used to go on vacation, purchase a car, or pay off credit cards would not qualify.

Cancellation of indebtedness is non-taxable to the extent that the debtor was insolvent just prior to the cancellation.

A debtor is insolvent immediately before the cancellation to the extent that the total of all of the debtor’s liabilities exceeded the fair market value of all of his or her assets immediately before the cancellation. It is important to note there that the definition of insolvency in this situation is very different from insolvency for the purposes of qualifying for a Chapter 7 bankruptcy.

Determining insolvency for IRS purposes does not allow any exemptions at all. Therefore, the IRS insolvency calculation includes assets normally exempt under bankruptcy such as retirement plans and household goods. Additionally, the IRS cancels debt to the extent that the debtor is insolvent.

Remember, tax liability from the cancellation of indebtedness income is non-dischargeable income tax debt under bankruptcy. The effective tax rate generally hovers around 20%. Therefore, a debtor should discuss these issues with an attorney. A good Orange County bankruptcy attorneys will be able to further explain the tax implications as it relates to bankruptcy.