Beware of Forgiveness of Your Debts

Cancellation of debt should be a good thing, but because of income tax rules pertaining to debt forgiven by a lender, it could be something that you need to look at carefully as you may incur tax liabilities.

Cancellation of debt (COD) in its basic form occurs when you borrow money from a commercial lender and that loan or a portion of it is later forgiven. The amount of money forgiven may be included in your income for tax purposes. COD income has become more of a concern for individuals and companies as lenders find it economically preferable to forgive a debt owed.

COD income can come about from many sources, but the most common are credit cards, automobile loans, student loans, second home mortgages and business lines of credit. In these cases, individuals who are offered a debt "workout" or a foreclosure may be in for a surprise when it comes to declaring taxable income.

Imagine your shock if a lender forgave $100,000 of your debt and you find that you now owe income tax on that amount or some portion of it. But, before you become too alarmed, remember that there are always exceptions in any tax law and in COD there are exceptions that may help you avoid some or most of the liability.

For instance, if you are in bankruptcy, the general debts discharged through this process are not considered taxable income. In a non-recourse loan where you are not liable to pay a debt, the COD income tax liability would not apply.

Another exclusion to COD income is when you are declared insolvent, i.e., when your total debt is greater than the fair market value your total assets. In this case, you may qualify for your canceled debt to be excluded from your income up to the amount you are insolvent. This concept is very dependent on the insolvency calculation.

Congress passed the Mortgage Forgiveness Debt Relief Act of 2007, which helps many homeowners who are in financial difficulty avoid the COD income tax liability issue. This law, along with rules governing the sale of a residence, applies only to your primary residence in most cases. This needs to be examined carefully because there are circumstances where even canceled debt on a primary residence may be taxable. And, if you have a second home or investment property, then the mortgage debt relief act may not be of any help.

Farmers can avoid the COD income tax liability if the debt was incurred in the operation of a farm and you can show that more than half your income in the prior three years was from farming. In that case, your COD income is generally not taxable. Professional assistance is warranted in these cases to be sure that the farm exclusion rules apply.

These articles are published for the use of our clients, advisors and friends. The technical information they contain is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. For additional information, please contact our firm.