Dealing with Cancelled Debt

Debt Cancellation and tax

Debt Cancellation and tax

One often complex financial matter is dealing with cancelled debt and taxation. Usually when a debt is cancelled by a lender you must include that amount in your taxable income. You must include the debt total as income because you owed this money to the lender then it was waived, so the tax department sees that as “profit”.

The lender will report the total for the canceled debt to the IRS on a “Cancellation of Debt” form. So even though you are escaping some debt, you may end up with a tax burden after the cancellation.

Luckily there are a few exceptions to this rule, which can mean a saving of a few thousands for many people. During the global financial crisis, the Mortgage Debt Relief Act passed and that act includes provisions that exclude tax payers from paying tax on mortgage related debt cancellation. This only applies to your principle residence however, but if you have run into debt troubles relating to your mortgage, this concession can be very important.

If you are in negotiations with your bank to have the debt total reduced or cancelled, then your potential tax burden is important to consider. So, mortgage debt which is forgiven via a foreclosure is covered and you won’t have to pay tax on the amount as long as it is your primary resident and the debt value is under $1 million for a single person or $2 million for a couple.

If the mortgage is for an investment property or holiday home, it is not your primary residence so you will most likely receive a tax bill for forgiven mortgage debt on those. The tax relief provision provided in the Mortgage Debt Relief Act continues for the 2013/2014 financial year at the very least, but it may not be renewed for 2015, something to consider if you are facing foreclosure or going to be negotiating with your lender.

The only other ways you avoid the cancelled debt tax burden is by bankruptcy or insolvency. An individual faces insolvency when their total debts are more than their total assets. Say for example you have some large credit card bill debts forgiven. Take a look at the remaining debts that you have as well as your total assets, you may be insolvent and be able to avoid the taxation bill for the cancelled debt. An IRS 982 form must be filled in to declare yourself insolvent and you should give the IRS a list of all debts and assets.

So before you sign up to debt cancellation or debt negotiation, consider the taxation ramifications for you and your family. A good accountant will help manage any potential risks with the process and provide some assurance of success.

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