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Is Cancellation of Debt Income?

September 20, 2018

Tax relief is a major part of our professional practice.  It follows, then, that we should expend some ink going over what constitutes taxable income.  One of the more confusing forms of taxable income is the phantom income known as cancellation of debt or, simply, COD income.   It’s the source of many bewildered telephone calls to this law firm.  Invariably its tax characteristics come as a shock to many of those on its receiving end.  In a nutshell, COD income can be thought of as a form of debt relief. Once we better understand it, we’ll look at its taxation.  We’ll then end by confusing our readers with an overview of general rule exceptions in which COD income may not produce any tax consequences.

Let’s start with a basic understanding of “income” since, significantly, income is the source of tax liabilities.  As with so many other terms in the tax lexicon, the meaning of “income” has developed gradually.  “Income” has been defined and this definition refined, over the course of many decades.  Legal cases have added layers to our current interpretation of the word. In fact, it’s possible to find hundreds of cases that made foundational contributions to today’s definition of income.

Notably, there are many different types of income. Some are intuitively understandable.  Incomes such as wages, sales proceeds, rents, interest, and dividends, are relatively common and understood by most people.  COD income, though, is different.

Cancellation of Debt Income Basics

The 1940 U.S. Supreme Court case of Helvering v. Bruun stands for the proposition that a person can be in receipt of taxable income when they’re placed in a financially superior position due a transaction.  That’s true even if no cash is transferred from one party to another. In Helvering, the Court found that a landlord received taxable income when a tenant built a structure on leased land and then defaulted before the lease terminated. The Court found taxable income existed even though no cash changed hands.  It did so based on the sizeable increase in value of the new structure built by the tenant and the old structure on the premises. This principle of “superior position” still forms a major part of our definition of taxable income.  

Using COD Income in an Example

Cancelled debt rules follow the  basic principle of Helvering.  Even though a debtor doesn’t affirmatively receive money, the law recognize taxable income due to the elimination of an obligation without full payment.  Let’s look at an example.  Suppose a taxpayer charges $5,000 on a credit card on a weekend getaway. After charging the $5,000, it’s easy to see that the taxpayer now has an outstanding debt of $5,000.  That amount, plus interest, must be paid back to the credit card company.

Now let’s further suppose that the taxpayer later runs into financial difficulties.  He or she  is unable to make the required, regular, payments to the credit card company. In that scenario, it’s likely that the credit card company may, at some point, write off all or a portion of the debt. Suppose, in our example, that the credit card company agrees to accept $1,000, or 20%, of the $5,000 debt in full payment.  The credit card company then forgives or cancels the remaining $4,000 principal balance, plus interest. This cancellation would trigger $4,000 of debt relief income to the taxpayer, based on the unpaid principal owed.  It would also trigger COD income equal to the interest owed. If our debtor receives cancellation of debt income in excess of $600, the credit card company will report this income to the IRS on Form 1099-C.

COD Income Exceptions 

Not all COD income is subject to tax, however. As we’ve alluded to, there may be exceptional circumstances which will cause COD income to not trigger a tax consequence. This happens in a handful of instances.  First, if the debt relief occurred in conjunction with a Title 11 bankruptcy filing.  Second, if the taxpayer was insolvent at the time the debt was forgiven (insolvent as specifically defined by the IRS.  Third, if the cancelled debt was qualified farm indebtedness.  Fourth, if the debt forgiven was qualified real property business indebtedness.  Lastly, if the debt forgiven was student loan debt and forgiveness was necessary because of death or permanent disability.

Notably, there are still other rules to consider, as well as additional exceptions to the general cancellation of debt income taxation rules.  Court cases, such as Zarin v. Commissioner   and Commissioner v. Rail Joint Co., provide insights into these exceptions to the standard rule regarding COD income. 

Tax Relief Attorneys

Cancellation of debt income taxation can sometimes be tricky depending on the exact facts presented. No matter what your situation may be, though, the New York tax lawyers at Mackay, Caswell & Callahan, P.C., can help. If you’ve just had a sizable debt forgiven, giving MCC a call is a wise decision. One of our top New York City tax attorneys can sit down with you and figure out the full implications of this relief. Our talented professionals deal with a wide variety of  tax and business law matters.  Don’t hesitate to reach out!

Image credit: Marco Verch 

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