Cancellation of debt is reported to the IRS on Form 1099-C, according to Connie Prater and Fred Williams for CreditCards.com. The IRS considers a cancelled debt as income, and a 1099-C is provided to the debtor and the IRS. The amount is reported on the Other Income line of the form, notes TurboTax.
There are some exceptions to the rule that cancelled debt be reported as income, explains TurboTax. One exception is debt a taxpayer no longer has to repay because of a bequest in a will. For example, if the taxpayer borrowed money from a friend and signed a promissory note, and the friend passed away and relieved the taxpayer of his obligation to pay the debt in the will, the debt cancellation is not taxable. If a mortgage balance is reduced under the Home Affordable Modification Program, that income does not have to be reported on a tax return.
Certain debt payments may be deductible on a tax return, states TurboTax. A business owner who operates a sole proprietorship can deduct many business expenses on Schedule C after he has paid them if using the cash method of accounting. If business expenses are incurred on credit and the obligation to pay them is cancelled, that amount is not reported on a tax return.