Cancellation of Debt Income

Say you loan a friend $10,000. He can't pay it back and you tell him to just forget it. Your friend has just received $10,000 in taxable cancellation of debt income.

Or, say you negotiate with a credit card company to lower the principal balance on a credit card debt, the amount that they write-off is also taxable cancellation of debt income.

What happens if your mortgage lender reduces the principal balance on your mortgage? What are the consequences of a short sell or a foreclosure? Example: If you owe $200,000 on your home and the lender agrees to accept $150,000, the $50,000 difference is cancellation of debt income (COD). Fortunately, if the home is your principal residence and the debt was forgiven between 2007 and 2012, that cancellation of debt income is excluded from your taxable income. However, if the property is not your principal residence, e.g. you rent it, the forgiven amount is taxable.

If you refinanced your home for an amount greater than the original first mortgage, the excess amount is taxable if the money you received was not used to improve your property. For example, if you borrowed $200,000 to purchase your house and later on refinance for $350,000, the extra $150,000 is not purchase money and, if forgiven, would be taxable. The same reasoning applies if you take out a 2nd mortgage and the money borrowed is used for such things as vacations, college tuition, etc.

Tax forgiveness income exclusion is only for homes up to $1 million for single individuals and $2 million for couples.

You are not liable for cancellation of debt income if you were insolvent at the time of the forgiveness. (The amount for which aren't liable depends on the extent of your insolvency.)

If your lender cancels a portion of your debt because of a loan workout or foreclosure, you will receive a 1099-C from the lender. Because the 1099-C generally involves a large amount of taxable non-cash income the resulting tax can have severe consequences.

You should consult a tax professional to discuss the tax implications of a loan workout or foreclosure. If filed in time, bankruptcy can prevent cancellation of debt tax issues. A bankruptcy/tax attorney can advise you. Visit my website TaxAttorneyCA.com to learn more about resolving tax problems.