Is a Charge-Off Considered Taxable Income?

Understanding Debt Charge-Offs and Tax Implications

A “charge-off” represents an internal accounting action by a creditor when they determine a debt is unlikely to be collected. This removes the debt from active accounts, reclassifying it as a loss on their books. While a charge-off does not eliminate a borrower’s legal obligation, it often precedes or relates to debt cancellation, which can have significant tax implications. Whether a charged-off debt is taxable depends on the specific circumstances of its forgiveness.

Understanding Debt Forgiveness and Taxable Income

The Internal Revenue Service (IRS) considers canceled or forgiven debt as taxable income, known as “cancellation of debt” (COD) income. This is because when a debt is forgiven, the borrower receives an economic benefit by no longer being obligated to repay a borrowed amount. This benefit is treated similarly to other forms of income for tax purposes.

While a charge-off is an internal bookkeeping entry, it is the cancellation of the debt that triggers potential tax liability. For example, if a credit card company charges off a debt and later settles it for a lower amount, the difference between the original debt and the settled amount is the canceled debt. This canceled amount can then be considered taxable income.

This concept applies to various types of debt, including credit card balances, personal loans, and some mortgage debt where a portion of the principal is forgiven. The IRS views the relief from financial obligation as an accession to wealth, thus subject to taxation.

How Creditors Report Canceled Debt

When a debt of $600 or more is canceled, the creditor is required to report this to the IRS and the taxpayer using Form 1099-C, “Cancellation of Debt.” This form informs both the IRS and the debtor about the amount of debt that has been canceled.

The form includes details such as the amount of debt canceled, the date of cancellation, and the type of debt. Receiving a Form 1099-C indicates the creditor has officially reported the canceled amount to the IRS. However, receiving this form does not automatically mean the taxpayer owes tax on the canceled amount; it merely signifies that the IRS has been notified.

Taxpayers should carefully review any Form 1099-C they receive for accuracy. Discrepancies should be addressed directly with the creditor. This document is important for taxpayers when preparing their annual income tax returns.

When Canceled Debt Is Not Taxable

Even if a Form 1099-C is issued, several exceptions and exclusions mean canceled debt may not be taxable income. One common exclusion applies if the taxpayer was “insolvent” immediately before the debt cancellation. Insolvency means total liabilities exceeded the fair market value of total assets. The amount of canceled debt excluded due to insolvency is limited to the extent of the taxpayer’s insolvency.

Debt discharged through bankruptcy proceedings is generally excluded from taxable income. This applies to debts discharged under the U.S. Bankruptcy Code.

Another exclusion applies to “qualified principal residence indebtedness,” which refers to debt for a main home later reduced through a workout or foreclosure. Certain types of student loan forgiveness, particularly those under specific public service programs or due to death or disability, are also generally excluded from taxable income.

Actions After Receiving a Form 1099-C

Upon receiving a Form 1099-C, a taxpayer should first carefully review the form for accuracy, verifying the canceled debt amount and the date of cancellation. If any information appears incorrect, the taxpayer should contact the creditor to request a corrected form.

Next, the taxpayer needs to determine if any of the aforementioned exclusions to taxable debt apply to their specific situation. This involves assessing factors such as their insolvency status at the time of cancellation, whether the debt was discharged in bankruptcy, or if it qualifies as principal residence indebtedness or a specific type of student loan forgiveness. If an exclusion applies, the taxpayer will need to report the canceled debt on their tax return but then exclude it from their taxable income.

To claim an exclusion, taxpayers typically file Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” with their federal income tax return. Due to the complexities involved in determining taxability and claiming exclusions, consulting with a qualified tax professional, such as a Certified Public Accountant (CPA) or an Enrolled Agent, is highly recommended to ensure compliance and proper reporting.