C.O.D. means Cancellation of Debt
Remember the good old days when COD meant “Cash On Delivery?” In today’s economy the COD acronym is more frequently understood to mean “Cancellation Of Debt” and can have significant tax consequences. Lenders will issue a Form 1099-C, Cancellation of Debt when they have released a borrower from liability for a debt.
When a debt is forgiven by a lender and the borrower is personally liable for repayment, the amount of debt forgiven is considered income to the borrower. The debt forgiven is considered cancellation of debt income and is generally taxable. For personal debts the amount forgiven is reported on Line 21 of Form 1040. However, there are both exceptions and exclusions to the general rule for including COD as income.
First, let’s look at the exceptions. These are situations where COD is never included in the borrower’s income: Student loans, purchase-money debt reductions, COD where payment would otherwise be deductible, and COD where income is otherwise excluded.
Exception for Student Loans There is an exception for student loans that are forgiven when the student works for a certain period of time in certain professions. This exception is most commonly seen for medical doctors who work in a geographic area underserved by the medical profession. Any debts forgiven, or payments made on behalf of medical professionals, under the Public Health Service Act (or a designated State program) are specifically excepted from the COD rules.
Exception for Purchase-money Debt Reductions COD after the purchase of a property may be excepted. Where a seller reduces the amount of the debt after the sale, the amount of the reduction is not treated as COD income. The COD is treated as a reduction of the purchase price. This exception only applies when the debtor is not in bankruptcy or insolvent.
Exception for COD Where Payment Otherwise Deductible When a taxpayer’s debt is forgiven, if payment of the debt would have given rise to a deduction, the COD is not taxable income. For example, if a rancher incurs veterinary bills for his animals and the veterinarian subsequently forgives part of the debt, the amount forgiven is not COD income because the payment to the veterinarian would otherwise be a deduction for the rancher.
Exception for COD Where Income Otherwise Excluded If the COD amount would be excluded due to some other provision of the tax law, then the amount is not included in income. An example is where a parent forgives a loan to a child and intends that forgiveness as a gift. Because the receipt of a gift is not income, neither is the cancellation of debt considered income.
Exclusions There are multiple exclusions available for COD income as well. They include discharge of indebtedness in bankruptcy, when a taxpayer is insolvent, for qualified farm debt, for qualified real property business debt, and for discharge of qualified principal residence indebtedness. The exclusions come with a price tag – there is a reduction of tax attributes to the extent that the COD income is excluded.
Exclusions in Bankruptcy When a taxpayer has COD in a Title 11 case the amount excluded is not taxable. Title 11 of the U.S. Code governs bankruptcy. In the ordering rules, exclusions in bankruptcy take precedence over the other exclusions.
Exclusions for Insolvency COD is excluded to the extent that a taxpayer is insolvent at the time the debt is cancelled. The Internal Revenue Code (IRC) defines the term “insolvent” as the excess of liabilities over the fair market value of assets. Insolvency is determined immediately before the discharge of indebtedness.
Exclusion for Qualified Farm Debt COD income can be excluded for “qualified farm indebtedness.” Qualified farm indebtedness is debt incurred directly in connection with the operation by a taxpayer in the trade or business of farming. For this exclusion to apply at least 50% of the taxpayer’s gross receipts for the preceding three years must have been from farming activities. Additionally, the amount excluded cannot exceed the taxpayer’s adjusted tax attributes. The adjusted tax attributes must be determined after applying any exclusion due to the insolvency rules for exclusion of COD income.
Exclusion for Qualified Real Property Business Debt COD income that arises from real property used in a trade or business can be excluded in certain circumstances. The COD income that can be excluded is limited to “qualified acquisition debt” – the amount of debt used to acquire, construct, reconstruct, or substantially improve the real property on which the debt is cancelled. This exclusion applies to real property debt incurred before January 1, 1993 or any qualified acquisition debt.
Exclusion for Qualified Principal Residence Indebtedness Excluding COD income from a qualified principal residence debt takes precedence in the ordering rules over insolvency. The amount of COD income excluded on a principal residence is limited where the acquisition debt exceeds $2 million ($1 million for married filing separate). The definition of a principal residence for excluding COD income is the same as the definition for excluding gain on the sale of a principal residence. California taxpayers have modified conformity to the federal rules with a debt ceiling of $800,000 and a maximum excludable amount of $500,000. Cut the California amounts in half for those with a filing status of married filing separate.
What Can I do About COD Income?
Cancellation of debt income and the related exceptions and exclusions are a complicated area of the tax law. Contact the tax professionals at Seid & Company, CPA’s if you need assistance in handling tax issues involving cancellation of debt.