What is Cancellation of Debt Income?

cancellation of debt (COD) income arises in favor of the debtor if the creditor forgives or writes off all or part of a debt. Under the United States Internal Revenue Code, this type of income can be taxable even if no cash is gained in the process. If your mortgage has been written off by your loan provider, you must include in your income tax return the amount that has been discharged. Typically, the cancelled debt is reflected in the gross income of the taxpayer and treated just like cash income. Still, there are exemptions to the tax rules applied to this type of income. Here are some important facts that you need to understand COD.

Forgiven Loans Not Considered as Cancellation of Debt Income

Generally speaking, the IRS will not impose taxes on discharged loans if the party that benefits from the debt cancellation is insolvent or has total liabilities that exceed total assets. It must be emphasized that a COD will only be exempted from tax if the discharged loan will not bring about a situation where the total liabilities no longer exceed the total assets of the debtor.  Thus, if your total asset value is $10,000 and your liabilities amount to $22,000, your discharged loan should not go beyond $12,000 for it to remain non-taxable.

Loans that are discharged as part of the decision of a bankruptcy court are also not deemed COD income and therefore not taxed. Since taxation policies during bankruptcy protection proceedings can be very complex, make it a point to get professional assistance to ensure the accuracy and appropriateness of the tax deductions that you will claim.

Loans that have been forgiven and converted into gifts are also not considered as cancellation of debt income. However, there could be tax implications to the private lender. If the total amount of forgiven loans exceeds $13,000, the debt cancellations will eat away a portion the lender’s personal lifetime gift tax exemption of $1 million. To prevent this, a private lender should only cancel a small amount of loan at a time.

Other types of loans that are not considered as income when cancelled include certain student loans, real estate business debts, and farm loans.

New Tax Policies on Cancelled Loans

Due to the 2007 mortgage crisis, the US Congress passed a law whereby mortgage debts on principal residences cancelled between 2007 and 2012 will not be considered as cancellation of debt income. However, the exemption applies only to mortgage loans not exceeding $2 million per husband and wife.

Moreover, a forgiven home equity loan that was used for purposes other than improvement or acquisition of the principal home will also not be eligible for the tax exemption, unless the borrower is under bankruptcy proceedings or is considered insolvent. A cancelled mortgage is also not exempted if you sold your principal residence in a short sale. In the end, it is always wise to get professional help before you file for tax exemptions arising from cancelled debts.



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