CANCELLATION OF DEBT INCOME
The proliferation of foreclosures, short sales, and other discharges of debt in the past few years have resulted in large tax bills for taxpayers because in many cases the debt that was cancelled is taxable income. The type of debt that is cancelled includes credit card debt, commercial loans, and mortgages. The majority of the cancelled debt the past few years has involved mortgages. The reason for this is because of the downturn in the real estate market. Generally any debt that is cancelled is taxable unless there is an exception in the tax code. There are six exceptions in the code. The following is a summary of the six exceptions:
1. Bankruptcy
If you have debt that is discharged in bankruptcy then that cancelled debt will not be taxable. Typically Chapter 11 bankruptcy filing cancelled debt is not taxable but other bankruptcy code provisions may apply as well.
2. Insolvency
When your liabilities exceed the FMV of your assets and it is likely that you will not be able to pay back your debts then you are insolvent. Most debts discharged in this situation are also not taxable.
3. Farmers
Income arising from the discharge of qualified farm indebtedness owed to an unrelated lender, including a federal, state, or local government or agency may be excluded from a taxpayer’s income if certain requirements are met.
4. Qualified Principal Residence Indebtedness
Excludable from gross income is any amount of income from the discharge, in whole or in part of “qualified principal residence indebtedness” which occurs on or after January 1, 2007. This indebtedness includes only acquisition indebtedness on the taxpayer’s primary residence.
5. Student Loans
A special income exclusion applies to the discharge of all or part of a student loan if, pursuant to the loan agreement, the discharge is made because the individual works for a specified period of time in certain professions for any broad class of employers.
6. Qualified Real Property Business Indebtedness
A taxpayer other than a C-Corporation may elect to exclude from gross income amounts realized from the discharge of debt incurred or assumed in connection with real property used in a trade or business and secured by that property.
Please feel free to contact Tom to discuss any questions you may have.
He may be reached at 916-781-2063.