If you own investment property and your lender agrees to forgive some of the debt you owe, this is called canceled debt. A lender may agree to cancel the remaining balance when you owe more on the mortgage than the property is worth. The amount of debt canceled typically is considered taxable income, but the IRS stipulates some exceptions.
Reporting Canceled Debt
When a creditor, such as a lender, reduces the amount you owe on a debt, the law requires the lender to send you Form 1099-C (Cancellation of Debt) if the debt forgiven is more than $600. Even if you do not receive the form, in most cases you are still required to report this as ordinary income on your tax return.
According to the IRS, canceled debt is nontaxable when forgiven under Chapter 7, Chapter 11 or Chapter 13 of the U.S. Bankruptcy Code. At the conclusion of your bankruptcy case, the court discharges your debts. If your canceled debt is the result of bankruptcy, you must notify the IRS by entering the amount on line 2 of Form 982.
Canceled debt is nontaxable when you are insolvent immediately before the lender cancels debt on your investment property. Under IRS rules, you are insolvent to the extent that your total liabilities are more than the fair market value of all your assets immediately before the creditor canceled your debt. When calculating the value of your assets, you must also include assets being used as collateral and exempt assets not available to creditors.
You can determine whether you must include the canceled debt as income by subtracting your assets from your liabilities, which will give you the insolvency amount If, for example, your liabilities total $15,000 and you have assets valued at $5,000, your insolvency would be $10,000. Of that amount you would not report as income the $5,000 that exceeds your assets. If, however, the amount of canceled debt exceeds insolvency, the excess must be reported as income. For example, if your liabilities total $15,000 and assets total $13,000, insolvency is $2,000. If $5,000 in debt is canceled, you must report $3,000 ($5,000 minus $2,000) as income.