When a lender decides to cancel a debt (most likely because it is deemed uncollectable) it usually is a benefit to the consumer despite the negative effect on his or her credit rating. Nevertheless, the cancellation of a debt could have important tax implications.
Essentially, the remaining debt may be considered taxable income, which could affect the amount you may owe the federal government come tax time. But like every rule, there are exceptions. This post will highlight a few debts that may be viewed as income.
Debt on your primary home – If the debt was used to purchase, construct or substantially improve your primary residence, chances are that a cancelled debt may not be considered income; especially if the debt secures your home.
Loan modifications – Debt that is set aside due to a modified loan, or debt cancelled through a loan workout may also be excluded as taxable income. This includes debt removed through HAMP modifications as well as debt cancelled through a foreclosure.
Refinanced mortgages – Like loan modifications, you may exclude debt cancelled as a result of a refinanced mortgage. The exclusion applies if you used the proceeds from a refinanced mortgage to purchase or substantially improve your primary residence.
Debt cancelled on business property, credit card debt and other forms of real property (i.e. rental property) generally does not qualify for the taxable income exception, but there may be instances where it may. An experienced tax attorney can help you understand when the exceptions apply.
The preceding is not legal advice.