Receipt of form 1099-C may not signal taxable COD income.

• Author: Bartlett, Victoria R.
• Position: Cancellation of debt

It comes as an unpleasant surprise to many clients that debt forgiveness is a taxable event. Sec. 61(a) (12) specifically cites discharge of indebtedness as gross income, while Sec. 108 excludes the discharge from gross income if it occurs under specific circumstances (see Sullivan, "Measuring Insolvency Under Sec. 108," on p. 786). In addition to having some difficult discussions with clients, advisers may face a challenge in determining when cancellation of debt (COD) income should be recognized.

Lenders are required to issue Form 1099-C, Cancellation of Debt, to borrowers for whom the lender has discharged or forgiven debt. However, taxpayers should be aware that a lender's obligation to issue Form 1099-C may not necessarily coincide with debt forgiveness or a requirement to recognize COD income.

Regs. Sec. 1.6050P-1 provides Form 1099-C reporting guidance to lenders and specifies that reportable debt cancellation is triggered at the occurrence of an "identifiable event" indicating the debt will not be repaid.

Within the regulation are eight circumstances under which an "identifiable event" is deemed to have taken place. One such circumstance is the expiration of a period of time during which there has been no payment or collection activity on the debt. The period of time, the "testing period," stretches for 36 months (extended for any months during which the lender is precluded from collection due to the borrower's bankruptcy or prohibitions under state law).

Does this provision mean that taxpayers should consider a debt discharged in a year after the expiration of the 36-month period, regardless of the lender's reporting or lack thereof? Unfortunately, the COD rules are not clear cut. Regs. Sec. 1.6050P-1(b) (1) states that the eight circumstances are outlined for Form 1099-C reporting purposes only; they do not by themselves indicate whether the taxpayer should include COD in income that year.

The Form 1099-C instructions advise that a debt is deemed canceled at the expiration of the testing period unless the lender can rebut the...