With the economy in a downturn, more and more companies are choosing to discharge money and debt owed to them instead of attempting to collect. When this discharge happens, the people receiving the discharged debt are initially happy to know that they no longer owe that company or that person. Unfortunately, debt cancellation has its downs as well as its ups.
Generally, if a debt is cancelled or forgiven, then the debtor must include the cancelled amount in their gross income for tax purposes. This means that the debtor’s amount of cancelled debt will be treated as income to the debtor, casuing the debtor to be required to report the cancelled debt amount on their federal income tax return.
However, there are several exceptions to the general rule that a cancelled debt is taxable to the debtor. The following is a brief list of the most common exceptions:
- The cancellation of a student loan for a student required to work for certain employers
- The cancellation of debt that would have been deductible if paid
- The reduction of a debt by the seller of property if the debt arose from the purchase of the property
- The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code
- The cancellation takes place when the debtor is insolvent and the amount excluded is not more than the amount by which the debtor is insolvent
- The cancelled debt is qualified real property business indebtedness
Although the cancellation of debt can be a good thing for a person, the debt must remember that there can be tax ramifications for the cancellation of their debt as well.