If a taxpayer has a debt forgiven, discharged, or cancelled for less than the amount owed, they generally have an obligation to report the taxable amount of debt as ordinary income on their tax return.

For example, a taxpayer has paid $8,000 toward a $10,000 loan. The remaining $2,000 is forgiven. That $2,000 is likely taxable income.

The individual or organization that cancelled the debt should provide the taxpayer with Form 1099-C, Cancellation of Debt. They will also send a copy to the IRS. In other words, the IRS is aware of the cancelled debt, and failing to report it doesn't hide the cancellation from the agency.

Even if a taxpayer doesn't receive Form 1099-C, they're still required to report the discharged debt. Before claiming a debt is cancelled, however, taxpayers should confirm with the creditor that the debt was actually cancelled.

In some cases, a creditor may send a Form 1099-C but still attempt to collect on the debt. If the creditor is still trying to collect the debt, taxpayers don't have to report it to the IRS.

Exclusions

Taxpayers don't have to report every type of cancelled debt. Debt cancelled as part of a Chapter 11 bankruptcy case doesn't count toward a taxpayer's gross income. Certain types of student loan cancellations and debt that's cancelled as a gift are also excluded from reporting requirements.

If an exclusion does apply, the taxpayer will need to file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This is to inform the IRS of the exclusion and that the forgiven debt is not taxable.

Failing to Report

As forgiven debt is generally taxed as income, this means that failing to report a cancelled debt is similar to not reporting any other type of income. Taxes on unreported debt will accrue interest and penalties.

In general, the best course of action a taxpayer can take, once they realize or learn they failed to report forgiven debt, is to address the issue as quickly as possible. The sooner they can reach a resolution, the less they will likely have to pay in penalties and interest.

If you have questions about how to report debt on tax returns, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.