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Debt Forgiven? You Are Not Home-Free - Tax May Apply to Cancellation-of-Debt Income

September 13, 2011

James J. Bailey Jr., MST, CPA, CFP®
Partner
BlumShapiro

Let’s say an individual owes money to a third party, relating to a loan for business or personal reasons.  Due to extenuating circumstances, the lender agrees to a settlement of an amount less than what the borrower owes in principal and interest.  So the full amount of debt is effectively wiped off the books. Case closed, right?

Not exactly.

The individual still faces potential federal income tax liability when a debt is completely or partially forgiven.  In other words, you must pay tax on the reduction of the debt from which you benefit.  Tax professionals commonly refer to this as Cancellation of Debt (COD) income.

If a debt is forgiven or canceled, the benefactor must report the amount as taxable income on his or her personal tax return.  A business debt is reported on the appropriate return for the business entity or sole proprietorship. For this purpose, a debt includes any indebtedness for which the party is legally liable, or indebtedness that attaches to property owned by that party.

Similarly, the debtor is required to report any interest attributable to the debt that is being forgiven or canceled. In lay terms, it’s a double hit.

Let’s take another case as an example.  Say a taxpayer who attended college in the 1980s borrowed money from the Connecticut Student Loan Foundation (CSLF) to help pay for school.  At some point, the taxpayer became delinquent in the payments, and eventually he settled the debt with CSLF by paying $45,000 of the $73,000 he owed, at a discount of $28,000.  However, a tax court would find that this taxpayer now owes tax on $28,000 of COD income.

Be aware, however, that there are several key exemptions to the rules for COD income, including student loans requiring the student to work after school for a specified time in a designated profession and certain student loans issued by tax-exempt organizations.  Also, COD income does not have to be realized if the payment of debt would have been tax deductible. (This exemption only applies if the cash method of accounting is used.)

Furthermore, the rules for tax on COD income generally do not apply to insolvent taxpayers or those in bankruptcy proceedings.  Other special rules apply to indebtedness of farms.

Finally, there is a specific exclusion from COD income for debt of a principal residence.  The exemption, which was established by a recent tax law in the wake of the mortgage foreclosure crisis, is capped at $2 million of qualified principal residence debt.  This tax break is currently scheduled to expire for debts discharged after 2012.

This is critical – a person should never simply assume that they are in the clear.  Professional assistance should be obtained regarding the tax consequences of debt forgiveness or cancellation, if the person really wants to know exactly what is owed and what the options are.

James J. Bailey Jr., MST, CPA, CFP®, is a partner with BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in West Hartford and Shelton, CT and Rockland, MA.  The firm serves as business advisors for today’s leading companies, non-profit organizations and government entities, working to strategically tailor and consistently deliver tested solutions for unlocking an organization’s full potential.  For more information about BlumShapiro, visit blumshapiro.com.

 

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