Sometimes debts can pile up beyond a borrower’s ability to repay, especially if we are heading into a recession.

But lenders are sometimes willing to cancel (forgive) debts that are owed by financially challenged borrowers.

While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event.

This analysis summarizes the most important federal income tax implications when debts are canceled. Here goes.

General Rule: COD Income Is Taxable

When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs.1

Fortunately, there are a number of exceptions to the general rule that COD income is taxable. You can find the exceptions in Section 108 of our beloved Internal Revenue Code, and they are generally mandatory rather than elective.2 We will cover the most important exceptions shortly.

Lenders Should Report COD Income to Borrowers and the IRS

In theory, lenders are required to report COD income amounts to borrowers in box 2 of Form 1099-C (Cancellation of Debt) for the year the debt cancellation occurs.

Any accrued but unpaid interest included in the box 2 amount should be reported separately in box 3.

The date of the COD event ... Log in to view full article.