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If you, like so many others, have found yourself over-extended – with a debt to income ratio that will not ever clear up? It happens -- especially if we are heading into a recession. And probably more often than anyone knows. However, sometimes lenders will cancel (forgive) debts that are owed by financially challenged borrowers. While that sounds great – it’s not without it’s downside.
While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event. There are many things to consider when choosing to take the route of having your debt forgiven. Following are some guidelines to consider.
When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs. Failure to claim this COD income will result in fines and penalties.
However, there are some exceptions to the general rule that COD income is taxable. While our Tax Code provides ALL the rules and regulations, and they are generally mandatory rather than elective, that could be a rather long, and boring, way to find out what that means for you. We have broken it down into some simpler terms for you.
There are two common exceptions to the COD income being taxable:
The process that allows the COD income from taxation under the bankruptcy or insolvency exception is a reduction of the borrower’s so-called tax attributes.
Generally speaking, you can reduce these tax attributes (future tax benefits) by one dollar for each dollar of excluded COD income. However, you also reduce tax credits by one dollar for every three dollars of excluded COD income.
Any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.
This taxpayer-friendly rule allows the borrower to take full advantage of any tax attributes available for the year of the debt cancellation before those attributes are reduced.
Another way to claim that COD tax-free --- a temporary exception, which was supposed to be a temporary solution, was implemented years ago and then repeatedly extended by Congress applies to COD income from qualifying cancellations of home mortgage debts that occur through 2025.
Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income—or $375,000 if the borrower uses married-filing-separately status—from the cancellation of qualified principal residence indebtedness. That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.
Note that the above exception is very specific – as stated above – this That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.
If you have found yourself with a cancellation of debt issue, and want to find the way out, call us today at 630-278-5023 to set up your complimentary consultation. Our certified tax planner and tax coach will help set up a plan that can save thousands of dollars a year by pro-actively creating a tax plan that will eliminate tax debt.