Anytime a debt is forgiven by a creditor, the IRS requires a 1099-C form. This form reports the amount of cancelled debt and generally implements the debtor in also claiming this amount as income on their tax return. Whether the debt is cancelled due to credit negotiations or a short sale, many debtors have found themselves in tax debt over such cancellations.
There are a few instances in which the IRS may not require a debtor to claim the cancelled debt as income on their taxes.
The first is financial insolvency, which essentially means the debtor holds debts that exceed his or her total assets. A debtor that is considered financially insolvent many not be required to claim a forgiven debt because it is considered “dry income”, meaning they have income but no expendable cash.
Bankruptcy may provide another loophole for claiming cancelled debt as income on tax returns. When a debt is forgiven in bankruptcy, the general rule applies that the debtor does not have to claim the amount of debts forgiven as income. However, they will be required to claim the bankruptcy filing and associated transactions to the IRS.
The last loophole comes in the form of a temporary tax break enacted during the foreclosure crisis. If a mortgage or home equity line of credit is forgiven by a lender because of a short sale or foreclosure before January 1st, 2013, the debtor does not have to claim this amount as income on their tax return. However, this tax break only applies to primary residence mortgages and does not apply to vacation, investment or second home properties.