The Result of Forgiveness of a Promissory Note Tax

Overview

When money is borrowed from a commercial lender and a portion of that debt is later forgiven by the lender, the borrower must typically recognize ordinary income on their individual income tax return for the period in which the debt is cancelled.
This rule applies for the restructuring of debts for which a portion of the debt is forgiven as well. For example, if a $20,000 promissory note balance is negotiated down to $15,000, the borrower must recognize $5,000 of income on the cancellation of debt when filing Internal Revenue Service Form 1040, U.S. Individual Income Tax Return.

Lenders are required to report cancelled debt to both the IRS and to the borrower using IRS Form 1099-C, Cancellation of Debt. This form must be filed by January 31 of the year subsequent to the tax year during which the debt was forgiven.
The lender is required to report the name, address and Social Security number of the borrower to the IRS. In addition, the lender must provide a brief description of the debt cancelled, the date the date was cancelled, and any interest included in the amount of debt cancelled. Interest cancelled does not need to be recognized as income by the borrower unless the interest is of a type that the borrower may also claim it as a tax deduction.

There are a number of specialized exceptions to the general rule that cancelled debt from a promissory note must be included as income. Most commonly, cancelled debt does not need to be reported as income if it cancelled pursuant a bankruptcy under Title 11 of the U.S. Code.
Additionally, The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude up to $2 million of debt from income if the promissory debt was secured by the taxpayer's principal residence.
Further exceptions include certain debts incurred in the operation of a farm and non-recourse debt for which you are not personally liable — such as some types of business debt.

When the promissory note is secured by real or personal property of the borrower that is relinquished — either voluntarily or involuntarily — the borrower generally does not need to include the fair market value of that property as income.
When a lending institution repossesses or forecloses on secured property — typically homes and vehicles, the secured property is usually resold and the net proceeds of the sale are applied to the balance of the borrower's debt. However, the borrower must recognize as income any forgiven debt beyond the fair market value of the secured property.