The Hidden Tax Trap in Debt Relief—and How to Dodge It

You finally caught a break — your lender forgave part (or all) of your business debt. But now the IRS wants a piece of that too?

That doesn’t seem fair. And yet… it’s real.

If you’ve had any debt forgiven — whether a business loan, credit card, lease, or a COVID-era relief program — you may be sitting on a tax problem without realizing it.

This article explains what Cancellation of Debt Income (CODI) is, why it matters, and how to handle it before it costs you more than it should.

What Is “Cancellation of Debt Income”?

When a lender cancels or forgives a debt, the IRS may treat that amount as taxable income. Even if no cash ever exchanged hands, that forgiven balance can increase your taxable income — and your tax bill.

Example:
If you owed $30,000 on a loan and negotiated a payoff of $20,000, the IRS could treat the remaining $10,000 as COD income unless an exclusion applies.

This often surprises business owners because debt relief feels like a financial win… until tax season.

Who Is Most Affected?

• Business owners who settled a loan or line of credit
• Individuals whose creditors wrote off balances
• Businesses that ended leases or financing early
• Entrepreneurs with forgiven COVID-era loans (EIDL, PPP)
• Owners navigating commercial or real estate debt modifications

What Happens If It’s Ignored?

• Unexpected increases in taxable income
• Higher tax liabilities and penalties
• Loan application or credit report issues due to inflated “profits”

How to Avoid the CODI Tax Trap

The good news? The IRS provides several key exclusions that can make forgiven debt non-taxable, if you meet specific criteria:

1. Insolvency Exclusion

If your total debts exceed your total assets immediately before the debt cancellation, the IRS allows you to exclude COD income up to the amount of your insolvency.

Tip: Use a professional appraisal to support asset values and document your liabilities.
File: IRS Form 982 to claim this exclusion.

2. Bankruptcy Exclusion

If the debt was discharged in a Title 11 bankruptcy case, you can exclude it from income — provided it was granted or approved by the court.

3. Qualified Principal Residence Indebtedness

If mortgage debt on your primary home was forgiven (via restructuring or foreclosure), you may be eligible to exclude it from income under specific provisions.

4. Farm Debt Exclusion

If the forgiven debt was directly tied to the operation of a farming business, and certain conditions apply, it may be excluded — even if the taxpayer was solvent.

5. Non-Recourse Loans

Forgiven non-recourse debt (where the lender’s only remedy is repossessing the collateral) generally does not trigger COD income at all.

What You Should Do Now

1. Identify: Review financials for cancelled debts and 1099-C forms.
2. Evaluate: Determine if you qualify for an exclusion (insolvency, bankruptcy, etc.).
3. Document: Gather all necessary financial statements, court documents, and appraisals.
4. File Correctly: Complete IRS Form 982 to report COD income as non-taxable.
5. Plan Ahead: Exclusions often reduce other tax attributes, so plan for future tax years too.

Why This Matters More Than Ever

In today’s economy, many businesses are restructuring or wrapping up relief programs. Without careful planning, these necessary steps can trigger unexpected taxes.

COD income isn’t just a tax technicality — it’s a potential liability that smart business owners must proactively manage.

Final Thought

Don’t let forgiven debt come back to haunt you. Understanding CODI and using the right IRS exclusions can protect your business from surprise tax bills — and help you keep the break you worked so hard to get.

Contact us here!

The Article “The Hidden Tax Trap in Debt Relief — and How to Dodge It” was originally posted Here.