Restructuring debt has become a common approach to personal financial management. But many people fail to realize that there’s often a tax impact to debt relief. And if you don’t anticipate it, a winning tax return may turn into a losing one.
Less debt, more income
Income tax applies to all forms of income — including what’s referred to as “cancellation-of-debt” (COD) income. Think of it this way: If a creditor forgives a debt, you avoid the expense of making the payments, which increases your net income.
Debt forgiveness isn’t the only way to generate a tax liability, though. You can have COD income if a creditor reduces the interest rate or gives you more time to pay. Calculating the amount of income can be complex but, essentially, by making it easier for you to repay the debt, the creditor confers a taxable economic benefit.
You can also have COD income in connection with a mortgage foreclosure, including a short sale or deed in lieu of foreclosure. Here, the tax consequences depend on which of the following two categories the mortgage falls into:
1. Nonrecourse. Here the lender’s sole remedy in the event of default is to take possession of the home. In other words, you’re not personally liable if the foreclosure proceeds are less than your outstanding loan balance. Foreclosure on a nonrecourse mortgage doesn’t produce COD income.
2. Recourse. This type of foreclosure can trigger COD tax liability if the lender forgives the portion of the loan that’s not satisfied. In a short sale, the lender permits you to sell the property for less than the amount you owe and accepts the sale proceeds in satisfaction of your mortgage. A deed in lieu of foreclosure means you convey the property to the lender in satisfaction of your debt. In either case, if the lender agrees to cancel the excess debt, the transaction is treated like a foreclosure for tax purposes — that is, a recourse mortgage may generate COD income.
Keep in mind that COD income is taxable as ordinary income, even if the debt is related to long-term capital gains property. And, in some cases, foreclosure can trigger both COD income and a capital gain or loss (depending on your tax basis in the property and the property’s market value).
Exceptions vs. exclusions
Several types of canceled debt are considered nontaxable “exceptions” — for example, debt cancellation that’s considered a gift (such as forgiveness of a family loan). Certain student loans are also considered exceptions — as long as they’re canceled in exchange for the recipient’s commitment to public service.
Other types of canceled debt qualify as “exclusions.” For instance, homeowners can exclude up to $2 million in COD income in connection with qualified principal residence indebtedness. A recent tax law change extended this exclusion through 2016, modifying it to apply to mortgage forgiveness that occurs in 2017 as long as it’s granted pursuant to a written agreement entered into in 2016. Other exclusions include certain canceled debts relating to bankruptcy and insolvency.
The rules applying to COD income are complex. So if you’re planning to restructure your debt this year, let us help you manage the tax impact.