Dear Tax Talk,
I renegotiated loans on a second home and a rental property, and the bank reduced the amounts added to principal from negative amortization. The loans are still more than the original amount. I received a 1099-C. Is this actually taxable income to me?
— Bill

Dear Bill,
The IRS has never seen the level of debt cancellation that is occurring as the economic crisis evolves. It has certain rules in place when it comes to cancellation, but the IRS and Congress (which makes the laws the IRS enforces) probably have not thought through all the different twists. The IRS has developed Publication 4681 to assist taxpayers with the myriad rules that apply to debt cancellations.

If a financial entity cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2. Unless you meet certain exceptions or exclusions, the canceled debt shown on Form 1099-C, box 2, is ordinary income from the cancellation of debt and must be reported on the appropriate tax form.

There are a variety of reasons that you can exclude canceled debt. There are exclusions if you’re insolvent or in bankruptcy. There is an exclusion for qualified real property used in a business. Forgiven interest may be excluded if it was otherwise deductible. Since the debt forgiven represents negative amortization, this exception is important for you.

If any interest is forgiven and included in the amount of canceled debt in box 2, the interest portion that is included in box 2 will be shown in box 3. Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it.

For example, the interest forgiven on the rental property should have been deductible if paid, and therefore it should not be income. The second-home interest may also be excludible based on the deduction exception.  

If the 1099-C does not show the correct interest figures, you should contact the lender to issue a corrected 1099. Since there can be various options available to you, you should consult with a tax professional on what is the best solution in your case.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.