Whether you need to report the debt forgiven may depend on what type of debt it was.
There are some exceptions to canceled debt that is reported on your tax return:
Canceled debt exceptions
One exception includes the debts you no longer have to repay because of a gift or a bequest made in a will. For example, suppose you borrow money from a friend and sign a promissory note. If your friend passes away and relieves you of your obligation to repay the loan in his will, the debt cancellation isn’t taxable.
A second exception applies to the cancellation of student loan debts resulting from your employment with a government agency or with an educational institution. And if your mortgage balance is reduced under a Home Affordable Modification Program, you don’t have to report it on your tax return.
Canceled debt exclusions
If your canceled debt doesn’t qualify for one of the exceptions, you should then determine if an exclusion applies to your situation. Exclusions commonly cover debts canceled on your primary residence, in a Chapters 7, 11 or 13 bankruptcy or other situations where you’re insolvent at the time the debt is canceled. You are insolvent if your total debt is more than the fair market value of your personal assets.
How to report
If you do not qualify for an exclusion or exception, your canceled debt is taxable and needs to be reported on the “other income” line of your tax return or on Schedule C if it relates to your sole proprietorship business.
If you qualify for an exception or exclusion, you don’t report your canceled debt on your tax return. However, when using an exception and it relates to property that you own, you may need to file a Form 982 to reduce your tax basis, or cost, in the underlying property if the debt relates to your insolvency or bankruptcy. This reduction in basis can increase the taxable gain that you'll recognize when you sell the property.
Click here for additional information regarding cancellation of debt and your taxes.
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