Cancellation of Debt Income
The past few years have been a financial struggle for many taxpayers. With the financial meltdown of 2008 came a wave of bankruptcies, foreclosures, short sales, and other types of discharged debt. These forms of cancelled debt also brought about tax consequences that many taxpayers were not aware of. Anytime a taxpayer has any type of cancelled debt there is a chance that the debt may be taxable. In this newsletter we will discuss the tax consequences of cancelled debt, the types of cancelled debt, and the various exclusions.
Requirements
The first step in determining if cancelled debt is taxable is to see if the debt is recourse or non recourse. The reason why this is important is because recourse type debt can be taxable whereas non recourse debt is never taxable. Recourse debt is a type of debt in which the creditor/lender has a legal recourse to collect the debt. This means that the lender can enforce the debt by suing the debtor to collect the debt. This can be done by obtaining a judgement and then attempting to collect the debt in various ways. With non recourse debt the creditor has no power or legal remedy to collect on the debt. The creditor cannot sue the debtor and cannot enforce the collections of the debt. After determining if the debt is recourse or non recourse the next step is to determine the type of debt that was cancelled. Was the debt mortgage debt? If so what kind of mortgage debt? Was the debt consumer credit card debt? Was the debt an auto loan? Was the debt a commercial loan? Why these types of debt are important is because certain types of debt are excluded from taxation.
Exclusions
After determining the type of debt that was cancelled the next step is to determine if the debt can be excluded from taxation based six exclusion allowed by the tax code. The exclusions are as follows:
- Qualified residence debt: In order for the debt to be excluded the debt/mortgage has to be used to acquire a personal residence of the taxpayer and the debt has to be secured by the residence. If the debt was used for anything other acquiring the residence then the cancelled debt may be taxable.
- Bankruptcy: If the cancelled debt was discharged in bankruptcy in most cases the debt will not be taxable. However, in some cases the debt could be taxable depending on the type of bankruptcy and if the debt was included in the bankruptcy discharge.
- Insolvency: At the time of the discharge of debt if the taxpayer’s total liabilities exceed the total assets then the taxpayer may exclude the debt from taxation.
- Student loan debt: In most cases cancelled student loan debt is excluded from taxation.
- Qualified business real estate debt: Certain types of business real estate debt may be excluded from taxation.
- Qualified farming debt: There are certain types of farming debt that may also be excluded from taxation
Tax consequences
If the debt is determined to be taxable the cancelled debt is then reported on the taxpayer’s tax return and is taxed as ordinary income. This type of income in many cases is unexpected by the taxpayer and the tax consequences can be significant. If a taxpayer knows that he or she will have any type of debt cancelled then it is recommend that they determine if the debt will be taxable and what the tax consequences may be.