In general, the Internal Revenue Service treats a cancellation or discharge of debt as income. You may wonder how you are to pay tax on the cancelled portion of a loan, if you did not have the money to pay the debt in the first place.
Only the debtor who benefited from a loan claims the cancellation of debt as income. When an individual co-signs a loan, he or she may receive no actual benefit and simply be a guarantor. The Treasury distinguishes between a debtor and guarantor, which means a co-signor probably does not need to include the discharged debt in gross income.
There are several exceptions that we will cover in this post.
Financial institutions issue Form 1099-C when an agreement results in forgiven debt. The IRS website lists codes on the form indicating some of the exclusions. For instance, Code A identifies debt discharged in Chapter 11 bankruptcy, which is excluded from income. A bank files this form with the IRS. So, if you receive a discharge of debt, but do not include it as income on your tax return it could result in an income tax audit.
Another exception is for insolvency. This might apply if your debts exceeded all of your assets before you received the debt cancellation. The IRS provides a worksheet for determining insolvency.
In some situations, you may have to pay on a portion of the cancelled debt. For instance, if your debts add up to $15,000, but you only have assets of $10,000, you are insolvent by $5,000. If your lender forgave $8,000 or your $15,000 home equity loan, you would need to claim $3,000 ($8,000 - $5,000 = $3,000) as income.
When you work out a negotiated debt settlement, there is the potential that it will be categorized income for tax purposes. Working with a tax attorney may help you avoid an audit down the road.
Source: Fox Business, "For Co-Signers IRS Won't Count Forgiven Debt As Income," Sally Herigstad, July 11, 2014.