There can be a lot of confusion surrounding a cancellation of debt event. Many taxpayers don’t even realize that one has occurred much less that it is taxable. This article discusses when a cancellation of debt event has occurred and what are the tax ramifications of debt cancellation in different situations. Let’s begin!
First, to have a debt cancellation issue, you must have had a bona fide debt. Were you legally obligated to repay an amount to another party? If the answer is yes, then you most likely have a debt.
Second, was part or all your debt canceled, forgiven, or discharged for less than the amount you owed? If yes, you have a cancellation of debt event.
Your debt cancellation is taxable, unless otherwise specifically excluded from tax. The following are some of the more common exclusions:
- Amounts cancelled as gifts (i.e. not a tax deduction for the gifting party)
- Education loans forgiven because you met the work requirements to cancel the debt
- Debt cancelled in a Title 11 bankruptcy case
- Debt cancelled while you were insolvent (debts exceed assets)
- Cancellation of qualified principal residence (your personal home) indebtedness before January 1, 2018
We often can reduce or eliminate your taxable cancellation of debt income subject to taxation using number 4 or 5 above.
If you can exclude your cancellation of debt income, congratulations! Otherwise, this phantom income gets added to all your other taxable income. Thus, you will pay your highest marginal tax rate on this income. Arggh!