Cancellation of debt (COD) is a trap into which many people unknowingly fall. If you owe money, and that debt is forgiven or discharged, you're left with COD income. For example, if you owed your credit card company $10,000 and they dismiss the debt, the IRS sees that $10,000 as gained income and requires you to pay taxes on it. The reasoning behind this phantom income is even though you don't actually have that income on hand now, at one point you did in some form or another, so you have to pay taxes on it.
Creditors who forgive more than $600 worth of debt are required by law to send out a 1099-C tax form, "Cancellation of Debt Income." You may not even know you owe taxes on COD income until you receive the 1099-C tax form in the mail. At least 6.3 million taxpayers were expected to receive 1099-C forms for the tax year 2012 [source: Martin]. If you receive one of these forms, Box 6 of the form typically has a code explaining the triggering event that generated the form. The code explanation is listed in IRS Publication 4681.
Even if you don't receive the 1099-C, but you did have cancelled debt, the IRS still expects you to report it on your income tax. If you're unsure if a 1099-C was filed for a cancelled debt, you can call the IRS at 800-829-1040 and request a transcript for the tax year [source: Detweiler].
If have COD income and are concerned that you now owe money to the IRS, all is not lost. Read on to learn about the many exemptions to this rule and find out whether you qualify for one of them.