A few folks have experienced having debt cancelled. The question is whether or not that cancellation of debt is taxable income.
It could be credit card debt that was reduced or cancelled. It might be a mortgage on real estate that was reduced or cancelled. Fortunately, Congress did some things right. There are several instances when the cancellation of debt is NOT taxable income. Here are a few examples.
The cancellation of debt in a bankruptcy case is usually not taxable income.
If you are insolvent, have more debts than assets, the amount by which you are insolvent, is not taxable income. For example if your total debts are $200,000 and your total assets (value of all you own) is $180,000, then you are insolvent (figured as of the date of cancellation). If the debt that was cancelled is $30,000, then $20,000 is not income, but the other $10,000 is taxable.
That is why it can be important to do a complete listing of all your assets and debts as of the date of the debt cancellation to see if the insolvency exception applies. We suggest a copy of that listing be included with your tax return or at least keep a copy for your files to answer any IRS questions.
If the debt is qualified real property business debt, the debt cancellation amount may just be a reduction of the tax basis in your business property. With a lower basis, you may find you have some gain when you sell it, but at least there is no taxable income in the year of the debt cancellation.
However, if the debt cancelled is on your personal home – your principal personal residence – than some other rules apply. If the debt is a mortgage secured by your home that you took out to buy, build or substantially improve than it is known as “Qualified principal residence indebtedness (QPRI)”. That can not be more than the cost of the home plus improvements. The maximum amount of this kind of debt that can be not taxable is $2 million for a joint return.
If you refinanced your home and got some money out to buy a car, etc. that will not qualify for relief from taxation for the cancelled debt. If you refinanced and used the money to improve your home, that does qualify as “acquisition indebtedness”. The debt must be secured by your residence.
We have a special two page list of all the many kinds of improvements that are done to our homes. It is a help to make the list of all the improvements you paid for to determine the total cost of the home. If you want a copy of that handout, just let us know. Most folks have to try to do a complete list of the improvements a couple of times. A few days after they do the first list, they then remember some other improvements to add to the list.
There are other rules for farmers. Cancellation of debt has lots of special rules.
Did you hear “The weak can never forgive. Forgiveness is the attribute of the strong”. Gandi.
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