Got debt. Got debt relief. Walked away. Now what? Generally, if you borrow money from a commercial lender and the lender later cancels or forgives either a portion or all of the debt, you may have to include the canceled amount in income for tax purposes, depending on the circumstances. There are some exceptions.
Debts discharged through bankruptcy are not considered taxable income.
Generally if you are insolvent (the total of all your liabilities exceeds the fair market value of all your assets) you do not have to include the canceled debt into income to the extent that you were insolvent immediately before the cancellation. There are certain rules that apply with regards to the insolvency exclusion.
For the years 2007 through 2012, you can exclude up to $2 million of discharged indebtedness ($1 million if married filing separately) from income if it is qualified principal residence indebtedness. If you own more than one home, determination of your principal residence is based on the circumstances that are particular to your situation. Qualified principal residence debt is the debt that is used to buy, build or make substantial improvements to your principal residence.
If part of the principal resident debt was not related to the acquisition, construction or improvement of your home, such as paying off a credit card loan, that unrelated portion of the debt would not qualify under this exclusion. If you exclude canceled qualified principal residence indebtedness from income and you continue to own the property, then you must reduce the basis of the residence (but not below zero) by the amount of the canceled qualified indebtedness excluded from income. This reduction in basis generally follows other types of cancellation due to bankruptcy or insolvency.
If the seller of a property reduces the amount of debt you owe for property you purchased, you do not have income from the reduction. Instead the reduction of debt is treated as a purchase price adjustment and reduces your basis in the property.
If the property is not your primary residence and you do not meet one of the various exceptions then upon foreclosure, repossession or abandonment you may realize income or loss. The calculation is somewhat similar to a sale or exchange, but is dependent upon several factors.
If you are in a situation that requires further evaluation please contact your HLB Gross Collins, P.C. representative.