A borrower may have taxable income to the extent a lender discharges the
debt owed. This is known as "cancellation of debt income". For
example, if a credit card holder owes $2,000 on the card, but the bank
agrees to cancel the debt, the holder now must declare an extra $2,000
of taxable income on his or her tax return.
While an additional $2,000 of income may not increase the tax due by very
much, a $50,000 (or more) increase in income certainly will. Depending
on the owner's tax bracket, an additional $50,000 in income could
add $12,500 to $17,500 in taxes due. These large debt cancellations are
common in foreclosures, short sales and loan modifications. For example,
say an owner buys property for $500,000. He puts $25,000 down and obtains
a loan for $475,000. Three years later, the value of the property has
gone down to $350,000 (not uncommon in this market) and the loan balance
is $450,000. The owner can no longer afford the property, and seeks the
least costly way to get rid of it.
If the owner simply walks away and allows the lender to foreclose, the
owner will have $100,000 in cancelled debt income (loan balance less market
value/purchase price). If the owner finds someone to purchase the property
for $375,000 in a short sale, he will have $75,000 in cancelled debt income
(loan balance less purchase price). Finally, if the owner obtains a loan
modification that reduces the principal loan balance to $400,000, he will
have $50,000 in cancelled debt income (original loan balance less reduced balance).
Luckily for most borrowers facing this issue, there are several situations
in which the cancelled debt is not included in a taxpayer's income.
These include certain student loans, gifts received, debt that was otherwise
deductible if paid, debt cancelled due to bankruptcy, debt cancelled while
the borrower was insolvent (e.g., liabilities exceed assets), and debt
cancelled on certain qualified principal residences.