J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

11.8 Cancellation of Debts You Owe

If a debt is cancelled or forgiven other than as a gift or a bequest the debtor generally must include the cancelled amount in gross income for tax purposes. Exclusions are allowed for discharges of farm or business real estate debt and debts of insolvent and bankrupt persons. If qualified principal residence indebtedness of up to $2 million is discharged before 2013 as part of a mortgage restructuring or foreclosure, the discharge is excluded from income. Details on the exclusion for qualified principal residence indebtedness as well as the other exclusions are provided below.

If you qualify for one of the exclusions, you generally must reduce certain “tax attributes” (such as the basis of property) by the amount excluded. The reduction of tax attributes is made on Form 982.

Form 1099-C.

You should receive Form 1099-C from a federal government agency, credit union, or bank that cancels or forgives a debt you owe of $600 or more. The IRS receives a copy of the form. Generally, the amount of cancelled debt shown in Box 2 of Form 1099-C must be reported as “other income” on Line 21 of Form 1040, unless one of the exclusions discussed below applies.

Mortgage loan “workouts” and repayment discounts.

If your lender agrees to a “workout” that restructures your loan and reduces the principal balance of your debt, or you are allowed a discount for paying off your loan early, the debt reduction or discount is considered cancellation of debt income if you ...