The COVID-19 pandemic has certainly made its mark on the economy, and your business might be dealing with increased debt. While lenders are at times willing to forgive or cancel debts, this can trigger negative tax consequences. So, what exactly are the tax implications of so-called “cancellation of debt” (COD) income? We dive in here.

What is COD?

Cancellation of debt, or COD income occurs when a lender forgives part or all of a debt. COD income generally counts as taxable gross income. The lender must report the forgiven amount to the borrower and to the IRS on Form 1099-C, Cancellation of Debt for the year when the COD income occurs. Luckily, there are several favorable federal income tax exceptions to help struggling borrowers at this time.

When is COD not taxable?

Here are exceptions to the general rule that COD income is taxable:

1. PPP loan exception- PPP loans (authorized by the CARES Act) can be forgiven if certain criteria are met and forgiven amounts are excluded from the borrower’s gross income for tax purposes. Read our blog for more about the requirements for PPP loan forgiveness. However, it should be noted that any amount of PPP loan that is forgiven will result in an equal amount of deductions reduced for covered expenses.
2. Bankruptcy exception- The COD income is tax exempt if the borrower’s debt is forgiven in a Title 11 bankruptcy proceeding. This includes filings under Chapter 7 (liquidations), Chapter 11 (reorganizations) and Chapter 13 (wage earner filings).
3. Insolvency exception- When the individual’s debts exceed the fair market value of his/her assets, a borrower is insolvent. When this happens right before debt cancellation occurs, the COD income that result is exempt from tax to the extent of the insolvency. However, taxpayers must also reduce tax attributes such as net operating loss carryovers, general business credit carryovers, alternative minimum tax credits, capital loss carryovers, cost basis of property, passive activity loss carryovers, and foreign tax credit carryovers.
4. Seller-financed debt exception- When a buyer finances all or part of a property purchase with a private loan from the previous owner, seller financed debt arises. When seller financed debt is forgiven, the COD income that results is tax exempt.
5. Student loan exception- A student borrower can exclude COD income amounts from taxes in certain instances. Cancellation of student loan debt is federal-income-tax-free provided the student works for a certain time period in certain professions for certain classes of employers. This includes debt incurred by those who work in public service, military service or teaching.
6. Home mortgage exception- An individual is allowed up to $2 million of federal income tax free COD income from forgiven qualified principal residence debt. The exception allows debt that 1) was used to acquire, build or improve your principal residence and 2) is secured by that residence.
7. Deductible interest exception- Any forgiven interest that you could have deducted if you had paid it is exempt from federal income tax (to the extent that COD income consists of unpaid interest that was added to your loan principal and then forgiven). This applies to forgiven vacation, residence and rental property mortgage interest.

Do you have COD income? If you need help assessing the tax implications, let us know.