Believe it or not, some lenders are still willing to forgive the debts of beleaguered consumers. While debt forgiveness can help you survive financially, it might also increase your tax bill. Here's what you need to know.

What is cancellation of debt income and how is it taxed?

When a lender forgives part or all of a debt, it results in so-called cancellation of debt (COD) income. As a general rule, COD income is taxable, and the lender is supposed to report the amount to you, and to the IRS, on Form 1099-C (Cancellation of Debt) for the year when the COD income occurs.

Thankfully, there are some favorable exceptions to the general rule that COD income is taxable. Here are the taxpayer-friendly exceptions that are most likely to help you out.

Bankruptcy Exception

If the COD income occurs while the borrower is in Title 11 bankruptcy proceedings, the income is completely exempt from federal taxation. Title 11 encompasses bankruptcy filings under Chapter 7 (liquidations), Chapter 11 (reorganizations), and Chapter 13 (wage earner filings). Legislation passed in 2005 made it more difficult to file for Chapter 7 bankruptcy protection, thereby making it harder to be completely exonerated from unsecured debts such as credit-card balances. However, COD income can still occur in Chapter 7 cases (just not as often), and it still occurs in some Chapter 11 and Chapter 13 cases as well.

One other thing to remember is that when you enter bankruptcy, a separate legal entity called the bankruptcy estate comes into legal existence. Once that happens, you must file tax returns for the estate, as well as for you personally.

Insolvency Exception

When a borrower is insolvent (meaning their debt exceeds their assets) but not in bankruptcy immediately before COD income occurs, the COD income is completely exempt from federal income taxation to the extent of the borrower s insolvency. However, when the COD effectively makes a person solvent (because the assets now exceed debts), the COD income is taxable to the extent of that solvency. Any remaining COD income will be exempt from taxation under the insolvency exception.

Home Mortgage Exception

Legislation in 2007 and 2008 created an exception for qualifying cancellations of home mortgage debt during the years 2007 through 2012. Taxpayers don't need to be bankrupt or insolvent to take advantage of this provision, which allows an individual to have up to $2 million of federal-income-tax-free COD income from forgiven qualified principal residence debt. This only includes debt that was used to acquire, build, or improve a main residence and that is secured by that residence. Refinanced debt can also qualify for this exception to the extent it replaces debt that was used to acquire, build, or improve a principal residence. You must reduce the tax basis of your residence (but not below zero) by the amount of COD income that you re allowed to treat as tax-free under this exception.

Deductible Interest Exception

If COD income includes unpaid interest that was added to a loan's principal and then forgiven, you may be in luck. Any forgiven interest that you could have deducted (had you paid it) is free from federal income taxation. This exception often comes into play with forgiven principal residence mortgage interest, vacation home mortgage interest, and rental property mortgage interest.

Seller-Financed Debt Exception

When COD income is derived from seller-financed debt (meaning mortgage debt that you owe to the previous owner of a property), it is exempt from federal income taxation. However, your basis in the property must be reduced by the amount that you re allowed to treat as tax-free under this provision.

The Bottom Line

There are some other more arcane exceptions to the general rule that COD income is taxable, but they are fairly unlikely to apply to most people.

One last thing to know is that the tax code extracts a price for allowing those who are in bankruptcy or insolvent to exempt their COD income from taxation. So-called tax attributes that these taxpayers have, such as capital loss carryovers, tax credit carryovers, and the tax basis of certain assets (used to calculate tax gains and losses and depreciation deductions) may have to be reduced. See IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness), which must be filed with your federal return. You must also file Form 982 if you take advantage of the home mortgage exception.

The good news is the exceptions explained in this article can prevent a major tax hit on COD income, which would really be adding insult to injury.