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.