Taxable Cancellation of Debt: What is it?
Taxable Cancellation of Debt is something of a dirty little secret. Here is an example of how it works. If you borrow $20,000 from somebody, pay back $5,000 and then default on the rest, there are a couple of bad things that can happen to you. You probably realize that the lender can sue you for the balance, as well as whatever fees are allowed under the terms of the agreement. But what if you convince the lender that your only assets are shielded from a judgment, and the judgment would, therefore, be uncollectible? Many people do not know that a lender can simply cancel the debt and issue the borrower a 1099 at the end of the year. For tax purposes the $15,000 of cancelled debt in our example would then be treated as income to you, and would likely result in a significant tax burden.
The IRS has identified several situations in which cancelled debt is not treated as income to the borrower, and they are as follows:
1. Debts discharged through bankruptcy;
2. Debts that are discharged while the borrower is insolvent;
3. Certain farm debts; and
4. Non-recourse loans.
Also, if you are a homeowner and have lost your home to foreclosure, The Mortgage Forgiveness Debt Relief Act of 2007 will generally allow you to exclude from taxation any income from the discharge of debt on your principal residence. This is a new rule and is of significant benefit to homeowners in foreclosure.
