Most folks know when they take out a loan it’s not treated as income and therefore there is no tax to be paid on it. But, if a loan is forgiven it suddenly becomes income. It’s called “Cancellation of Debt Income” which is often referred to in shorthand as COD Income. The idea is that you got cash when you borrowed the money, but when you don’t have to repay it the cash is no longer a loan. The tax code not only taxes you when you are relieved of paying back a debt, in other words, treating it like cash paid to you. Many people get caught in this trap they’re simply relieved that their loan has been forgiven. If your loan was from Uncle Charlie it may not be a problem. However, if it was from a bank or other institution you may receive a Form 1099C from that institution. This form is reporting income to you and a copy of it is also going to the IRS. If you receive one of these forms and disagree with the amount shown, write the lender requesting a corrected Form 1099C. Here are some tips to help you avoid getting taxed on Cancellation of Debt Income:
1. If the loan was cancelled or forgiven by a relative or a friend, then it may just be treated as a gift and there is no income to you. As a side note, if the loan was in excess of $13,0-00 in a single year it may have gift tax implications for the individual who loaned you the money.
2. There is an exception for the forgiveness of mortgage debt on your home. Because of the mortgage crisis Congress allowed a couple to exempt up to $2 million in mortgage debt forgiveness on their principal home. This only relates to a loan on your principal residence and there are details that come into play. See a tax expert if you are seriously considering this exemption.
3. Insolvent. If you are “insolvent” when your debt is forgiven, there is no tax. In order for this to apply you must be able to prove that your liabilities exceed your assets by more than the amount of the debt that’s being discharged.
4. Bankruptcy debt. If your loan is discharged in a Court of Bankruptcy it will not create a tax debt. You should seek the advice of a tax professional or a tax attorney or a bankruptcy attorney.
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