Forgiven Debt Could Equal Taxable Income

February 11, 2010 | Subscribe to our RSS Feed

In these troubled economic times, many financially distressed borrowers may have had some or all of their debt cancelled or forgiven by their lender last year. While such relief was no doubt welcome to people who received it, what they may not have realized is that debt forgiveness may have tax consequences. Specifically, debt forgiven in 2009 may have to be included as income on your 2009 return. However, not all canceled debts trigger taxable income.

General rule: The tax laws specifically include income from the discharge of indebtedness in gross income. However, there are several exceptions to this rule. In addition, there are numerous exclusions from gross income for certain types of forgiven debts.

Exceptions:

• If the cancellation of debt by a private lender, such as a relative or friend, is intended as a gift, there is no income. Likewise, a debt canceled by a private lender’s Last Will and Testament triggers no income to the borrower.

• There is also an exception for certain student loans. For example, doctors, nurses, and teachers agreeing to serve in rural or low income areas in exchange for cancellation of their student loans won’t have income from the cancellation if they meet certain conditions.

• Also keep in mind that there is no income from cancellation of deductible debt. For example, if a lender cancels home mortgage interest that could have been claimed as an itemized deduction on Schedule A of Form 1040, there is no tax problem to contend with.

• Price adjustment. There is no income if an individual purchases property and the seller later reduces the price. The purchaser’s basis (yardstick for measuring gain or loss on a later sale) in the property, however, is reduced by the amount of the purchase price adjustment.

Exclusions: In addition to the above exceptions, there are exclusions from the general rule for reporting canceled debt as income for:

• discharge of debt through bankruptcy,
• discharge of debt of an insolvent taxpayer,
• discharge of qualified farm debt,
• discharge of qualified real property business debt, and
• discharge of qualified principal residence debt.

These exclusions are quite complicated and you should have a detailed discussion with a tax advisor to determine if you qualify.

Submitted by Sam Cohen

Questions:

sam.cohen@glassjacobson.com