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When is cancelled debt treated as taxable income?

Given that Tax Day 2017 is still roughly six weeks away, it would not come as anything of a surprise to learn that there are still many people who have yet to complete their federal income tax returns. For some, this delay may have to do with their accountant's busy schedule, while for others it may have to do with simply finding the necessary time.

Still others, however, might be delaying the matter owing to some underlying apprehension about sitting down to complete what always seems like a difficult undertaking and, of course, the fear of making what could prove to be a costly mistake.

Regarding this last point, one topic that often causes taxpayers some consternation is debt cancellation.

In the majority of circumstances, debt cancellation, whether partial or complete, is treated as taxable income, meaning an individual will indeed be required to report and pay taxes on this amount.

There are a few exceptions to this requirement to treat debt cancellation as taxable income, however, and they relate solely to homeowners and mortgage debt:

  • Principal residence: If the cancelled debt relates to a loan on a person's principal residence or main home, it may be excluded from income if 1) the loan was used to buy, construct or substantially improve the main home and 2) the mortgage is secured by the main home.
  • Loan modifications: If a portion of the mortgage debt was cancelled via a loan workout or modification, it may be excluded from income.
  • Refinancing: If a portion of the mortgage debt was cancelled as a result of refinancing, it may be excluded from income provided the proceeds from refinancing were used to buy, construct or substantially improve the home. Furthermore, the exclusion applies only up to the amount of the old mortgage principal just prior to the refinancing.

If a lender cancelled or reduced any other type of debt -- credit card, rental property, car loans, etc. -- in an amount of $600 or more, you should receive a Form 1099-C, Cancellation of Debt, which outlines the necessary information to include on your tax return.

As for debt that can be excluded, it must be reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, which must be included with your federal income tax return.

What all of this serves to underscore is that doing your taxes can sometimes prove to be an incredibly difficult and incredibly frustrating process. As such, those in this situation should strongly consider the possibility of working with a professional who can guide them through the process and grant them the necessary peace of mind.

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