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A Simple Guide to Understanding Business Tax Terms for Canceled Debts and Losses

Taxes can be complicated, especially when it comes to business taxes involving canceled debts and losses. This guide aims to explain some key tax terms and concepts in simple, easy-to-understand language that any small business owner can grasp—no accounting degree required!

What is Canceled Debt?

In basic terms, canceled debt refers to when a lender forgives or discharges part or all of a loan or debt you owe. For example, let’s say you owe $10,000 on a business loan, but the lender agrees to accept $8,000 as payment in full. That $2,000 difference between what you owed and what you paid is considered canceled debt.

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Other common situations where canceled debt occurs include:

  • Negotiating a lower payoff amount on a loan
  • Having a portion of your debt wiped away in bankruptcy
  • Reaching a settlement where the lender accepts less than the full balance

The technical tax term for canceled debt is “discharge of indebtedness.”

Is Canceled Debt Taxable Income?

In most cases, yes—the IRS generally considers canceled debt to be taxable income. This comes from the principle that borrowing money does not count as income, but having your debt forgiven does.

Here’s a simplified example:

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  • You borrow $10,000 – Not taxable
  • The lender later cancels $2,000 of what you owe – That $2,000 canceled debt becomes taxable income

So unless an exclusion or exception applies (more on that below), any amount of debt forgiveness you receive will be treated as taxable income that must be reported.

When Will I Get a Form 1099-C for Canceled Debt?

If you have over $600 of canceled debt in a calendar year, the lender is required to report that amount to the IRS on Form 1099-C. As a borrower, you should receive a copy of this form by January 31 of the following year.

It’s crucial to review Form 1099-C and make sure the information is accurate. If any amount is incorrect, contact the lender right away to have them correct it. Otherwise, you may end up paying taxes on canceled debt you didn’t actually have.

Do Any Exceptions or Exclusions Apply?

Fortunately, there are a number of exceptions and exclusions that allow you to avoid paying tax on canceled debt, including:

Bankruptcy

Debt discharged through bankruptcy is not considered taxable income. This applies to both Chapter 7 and Chapter 13 bankruptcy filings.

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Insolvency

If you can prove you were insolvent (liabilities exceeded assets) immediately before the debt was canceled, it does not count as taxable income. You will need to file Form 982 with your tax return to claim insolvency.

Non-recourse debt

Debt that is secured only by certain property, like a home mortgage, is called non-recourse debt. Forgiveness of non-recourse debt is not taxable beyond the value of the collateral.

Student loans

Certain student loan debt forgiven through government programs is not taxable.

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Mortgage forgiveness

Up to $2 million of forgiven mortgage debt from your primary residence may be excluded from income tax through 2025.

Gifts and bequests

If someone simply gifts or bequeaths you money that you use to pay off debt, it does not create taxable canceled debt.

Deductible business debt

If the canceled debt relates to a business deduction you previously claimed, that amount may not be taxable.

As you can see, canceled debt is not automatically taxable in every scenario. Consult a tax professional to determine if any exceptions or exclusions apply to your specific situation.

How Do Business Losses and Deductions Factor In?

Operating losses are a natural part of doing business, and the tax code provides certain deductions to help offset those losses:

Net Operating Losses (NOLs)

If your business deductions exceed your income for the year, the result is an NOL. You can “carry back” an NOL up to two years to receive a refund on past taxes paid. Any remaining NOL can be “carried forward” up to 20 years to reduce future taxable income.

Passive Activity Losses

Losses related to passive income sources like rental real estate can only be used to offset additional passive income—not ordinary business income. Any excess passive losses carry forward until you generate enough passive income to use them.

At-Risk Limitations

Your ability to claim business losses is limited to the amount you have “at risk”—the capital and loans for which you are personally responsible. Losses exceeding your at-risk amount carry forward.

Hobby Losses

Losses from activities not engaged in for profit (hobbies) cannot offset other income. You can only deduct hobby expenses up to the amount of hobby income.

Thoughtful tax planning and working with a professional can help you maximize the deductions available for your business losses.

Key Takeaways

  • Canceled debt is generally taxable income, unless an exclusion or exception applies
  • Review Form 1099-C carefully for any canceled debt you receive
  • Bankruptcy, insolvency, and certain other situations allow tax-free debt cancellation
  • Net operating losses can provide deductions for business losses and canceled debt
  • Limitations exist on loss deductions from passive activities and hobbies

I hope this guide has helped explain some key tax terms and considerations around canceled debts and losses in plain English! Taxes can be confusing, but a little education goes a long way.

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