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Understanding Your Tax Obligations When Your Debt Has Been Canceled

All Americans have an obligation to pay taxes on the income they acquire during a given year. When preparing a tax return, however, it is important to understand that the Internal Revenue Service’s definition of “income” includes far more than just wages earned from employment. For example, the IRS requires taxpayers to claim canceled debts as income.

Simply put, “cancellation of debt income” refers to any obligation to repay a lender that is forgiven, canceled or discharged for less than what was originally owed. For example, if a person borrowed $10,000, repaid $4,000 of it and the lender agreed not to attempt to collect the rest, that person would have $6,000 in cancellation of debt income.

Generally speaking, most cancellation of debt income is taxable. However, there are some notable exceptions to this rule. The two most common exceptions are discussed below.

The Effect Bankruptcy And Insolvency Have On Your Taxable Income

Debt that is canceled as part of a bankruptcy case (including Chapter 7, Chapter 11 and Chapter 13 bankruptcy) does not count as taxable income. This applies both to unsecured debts like credit card debt and medical bills, along with secured debts in which property is repossessed to satisfy the loan.

In addition, debt that is canceled immediately before the borrower becomes insolvent is also excluded from taxable income. “Insolvency” means that a person’s liabilities are greater than the value of all of his or her assets. It is important to note, however, that depending on the extent of the insolvency, it is possible that not all cancellation of debt income will be excludable.

Qualifying For Mortgage Debt Forgiveness

As part of the financial crisis, many homeowners have found themselves with mortgage payments they cannot afford or homes that are worth far less than the amount owed on the mortgage. As a result, many have lost their homes to foreclosure, sold them in a short sale or had their mortgage debt reduced in a loan modification.

Canceled mortgage debt qualifies as taxable income. A law that excludes certain mortgage-related debt from being considered taxable income, called the Mortgage Forgiveness Debt Relief Act of 2007 initially covered the period between 2007 and 2010, but was extended four times to 2016. This can also apply to debt that is discharged in 2017 provided there was a written agreement entered into in 2016. This act offers relief to homeowners who would have owed taxes on forgiven mortgage debt after facing foreclosure. There is still a chance that Congress may extend the law further.

Concerned About Your Upcoming Income Tax Bill? Talk To One Of Our Attorneys Today.

This is just a brief overview of some of the rules pertaining to the complex topic of cancellation of debt income. If you have questions about how your canceled debt will be treated at tax time, it is best to discuss them with a qualified professional. If you are struggling with debts you cannot afford to pay, an experienced bankruptcy attorney can help you work with your creditors to discharge your debts and move forward with your life.

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Contact us to schedule a free initial consultation with one of our lawyers. You can reach us by filling out our online form or by calling 973-323-2953. Our firm serves residents throughout New Jersey.

We are a debt relief agency. We help people file for bankruptcy relief under the Bankruptcy Code.

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