Cancellation of Debt Income Exceptions

Cancellation of Debt (COD) provides actually provides a tax payer with a form of income. When a borrower takes a loan to purchase an asset, their buying power has increased by the size of the loan. This is a form of income, but it is not taxed because the Internal Revenue Service (IRS) knows the taxpayer will repay the sum, plus interest. However, when the lender agrees to forgive the debt, the income stays with the taxpayer. This results in additional income taxes on a yearly basis.

COD Exceptions

The COD rule does not apply across the board. There are four scenarios in which COD income will be forgiven due to extenuating circumstances. In order to qualify under these scenarios, the taxpayer must be liable for the debt and it must be secured against a property. If these qualifications are present, the COD income will be excluded if:

  1. The discharge is due to title 11 bankruptcy
  2. The discharge occurs due to insolvency
  3. The discharge is for qualified farm debt
  4. The discharge is for qualified real property business debt

In addition to these four exceptions, COD income is not taxed if a student loan is cancelled because a borrower worked for a qualified company For example, a borrower who had debt cancelled by participating in the Peace Corps program will not owe taxes on the forgiven sum.

Mortgage Forgiveness Debt Relief Act

One temporary exception to COD income tax was also put in place after the 2007 housing market collapse. The act allows for up to $2 million in mortgage debt forgiven between 2007 and 2012 to be forgiven. The act provides for relief by not taxing income earned through forgiveness of debt in a mortgage or foreclosure on a principal residence. The goal of the Mortgage Forgiveness Debt Relief Act is to give some shelter for the thousands of Americans who lost their homes due to the spiraling recession and credit crisis following the 2007 market crash. 

Receiving COD Income Exceptions

If you feel you qualify for a cancellation of your COD income, you must determine if you are eligible. The most prudent way to go about this determination is by consulting a tax professional. Discuss the sum you have been forgiven and determine whether it meets one of the narrowly-defined exception rules. If so, you must still declare the income on your tax statement, but you should also note the fact the income will be excluded because you qualify for an exception.

Paying Tax on COD Income

You will have to pay tax on COD income if you do not qualify for an exception. Failing to do so is the same as failing to pay income taxes. You will be considered guilty of tax avoidance, and you may even be held criminally liable if the sum is large. Therefore, it is best to consider the impact of loan forgiveness before determining the best course of action to resolve a loan you cannot afford. You will likely save money and your credit score by exploring options for refinancing or settling the debt.