Cancellation of Indebtedness (COD) occurs when you are discharged from a debt.  The debt may be in the form of a mortgage, credit card, loan, state and local taxes, etc.  The debt could be held by a financial institution, governmental agency, corporation, partnership, LLC, individual or a related party.

In Part 1 we will discuss COD’s that are taxable. 

The most typical COD’s relate to mortgages and credit cards.  In a mortgage situation, typically you have personally guaranteed the mortgage.  After you default on a mortgage the bank might foreclose on the property.  Let’s say the mortgage was $200,000 and the fair market value of the property was $150,000.  The bank has decided to release you from your personal guarantee.  In other words the bank will not look to you for additional payments after they have taken the property.  You now potentially have taxable COD income of $50,000.  In that year the bank will issue Form 1099-C which will state that you have COD income of $50,000.

Forgiveness of credit card debt works similarly.  Assume you owe $20,000 on a credit card and cannot pay the balance or minimum payments.  You negotiate with the company and pay $1,500.  The company accepts your offer and releases you from any further personal liability.  You potentially have taxable COD income of $18,500.  The company will issue Form 1099-C which will state that you have COD income of $18,500.

In both of these examples the COD will be taxable in the year the debt is forgiven.

There are situations where there is uncertainty as to which year that the COD is taxable.  In the real estate example above, let’s assume that the bank did not release your personal guarantee.  The bank took possession of the property or accepted a short sale.  The bank then thinks that at some time in the future you may have the ability to make a payment on the part of the debt that was forgiven.   In that case the bank will not issue Form 1099-C, but may issue Form 1099-A.  Until the bank releases your personal guarantee, you do not have taxable COD.  That could be forever.  The tax courts, however, have ruled consistently that at the end of 36 months, after the property was taken from you, the COD is taxable in that year.

There may be light at the end of the tunnel.  We will discuss in Part 2, the provisions of the Internal Revenue Code that make some or all of the COD non taxable.

If you have any cancellation of debt and are wondering if it is taxable, please contact us.