CODI Tax: How to Avoid Tax on Canceled Debt

When a lender forgives a debt, the Internal Revenue Service (IRS) considers the canceled amount as taxable income. This concept is known as Cancellation of Debt Income (CODI). The underlying principle is that when you are relieved of the obligation to repay money you previously borrowed, you have an accession to wealth. This means the forgiven amount is treated as if you received that sum in cash, and it must be reported on your tax return for the year the cancellation occurs.

The rule is that all canceled debt is included in your gross income, whether the debt was from a credit card, a personal loan, or a mortgage. You received funds without the typical tax consequence at the time of borrowing because of your legal duty to repay. Once that duty is extinguished for less than the full amount, the economic benefit you realize is subject to income tax.

Identifying Cancellation of Debt Income

A cancellation of debt is triggered by an “identifiable event,” which is an action that makes it clear a debt will not be collected. Examples of identifiable events include a formal debt settlement agreement, a mortgage foreclosure, the repossession of property, or a loan modification that reduces the principal balance of what you owe.

The primary way a taxpayer is notified of a potential CODI event is by receiving Form 1099-C, Cancellation of Debt, from the lender. Any creditor that cancels $600 or more of debt is required to file this form with the IRS and send a copy to you. This form is sent by January 31 of the year following the debt cancellation. For instance, if a debt was canceled in 2024, you should expect to receive a Form 1099-C by the end of January 2025.

The Form 1099-C contains specific details about the event, such as the amount of debt discharged, the date of the identifiable event, and a description of the debt.

The issuance of a Form 1099-C does not automatically mean the amount shown is taxable income. It serves as an official notification that a cancellation has occurred. The taxpayer is then responsible for determining whether the amount is fully taxable or if they qualify for an exclusion.

Common Exclusions from Gross Income

Several provisions in the tax code allow taxpayers to exclude canceled debt from their gross income. One of the most comprehensive exclusions applies to debts discharged through bankruptcy. If a debt is canceled as part of a Title 11 bankruptcy case, such as a Chapter 7 or Chapter 13 filing, the discharged amount is not considered taxable income. This exclusion covers all debts discharged within the bankruptcy proceeding.

Another exclusion is for insolvency. The tax code defines insolvency as a financial state where your total liabilities are greater than the fair market value (FMV) of your total assets immediately before the debt cancellation. The exclusion is limited to the amount by which you are insolvent. For example, if you have assets worth $50,000 and liabilities of $80,000, you are insolvent by $30,000. If a creditor cancels a $40,000 debt, you can only exclude $30,000 of that canceled debt from your income; the remaining $10,000 would be taxable.

A third exclusion is for Qualified Principal Residence Indebtedness (QPRI). This rule applies to mortgage debt on a taxpayer’s main home that was used to buy, build, or substantially improve that residence. For tax years 2021 through 2025, the maximum amount of forgiven mortgage debt that can be excluded is $750,000 for most filing statuses. This provision allows homeowners who have undergone a loan modification, foreclosure, or short sale to avoid a large tax bill on the forgiven mortgage balance.

Required Tax Reporting and Forms

If the canceled debt is taxable because no exclusion applies, the amount is reported as “Other Income.” This is done on Schedule 1, which is an attachment to the standard Form 1040 individual tax return. The amount reported is the canceled debt figure shown on the Form 1099-C you received from the lender.

To claim an exclusion, such as insolvency or the QPRI exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form must be attached to your tax return for the year the debt was canceled. On Form 982, you will check the box that corresponds to the specific exclusion you are claiming and enter the amount of the discharged debt you are excluding from income.

A consequence of using an exclusion is the requirement to reduce certain tax attributes, which is the “cost” of excluding the canceled debt from income. Tax attributes are items that could lower your taxes in future years, such as net operating losses, certain tax credits, or capital loss carryovers. The basis of property is another attribute that may need to be reduced. For example, if you exclude $30,000 of canceled debt due to insolvency, you must reduce your tax attributes by that same $30,000 on Form 982, which limits your ability to use them to offset future income.