Cancellation of Debt

/ October 10, 2013

We have written here at Epilawg about a handful of tax topics, mostly related to estate or gift taxes. What has not been discussed is cancellation of debt (C.O.D.) taxation, which could have quite an impact on a person’s estate.

What is C.O.D.?

Depending on the circumstances, cancellation of debt taxation may arise if you borrow money and the lender later cancels or forgives the debt; the amount forgiven could be considered income to you and, therefore, the amount forgiven will be treated as income to you and you will pay income taxes on that amount.

The thought process is: when you borrow the money – whether to attend school or purchase a home, as examples –  you are not required to include the loan proceeds as income because you have an obligation to repay the lender. If that obligation is subsequently forgiven, the amount that was forgiven is income to you because you no longer have an obligation to repay the lender.

When does C.O.D. occur?

House - iStockC.O.D. has come up quite a bit in recent years due to the mortgage foreclosure crisis. Many homeowners under the threat of foreclosure sometimes will opt to attempt a short sale or a deed-in-lieu-of-foreclosure to help avoid owing any deficiency between the price of the home and the amount owed on the original loan. By doing this, however, these homeowners open themselves up to C.O.D. So, many homeowners not only run the risk of losing their homes, but also owing thousands in income tax.

When homeowners modify loan terms significantly, that too will be treated as C.O.D. income. Significant modifications include a change in the interest rate of at least 25 basis points or a 5% change in the annual yield.

Thankfully, the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) allows C.O.D. taxation on debt forgiven on a principle residence. The MFDRA has been extended through 2013. Secondary loans on a primary residence can also be exempt from C.O.D. taxation, but only if the money was used to improve the home; not to pay other bills. Investment and secondary properties are not covered by the MFDRA.

Exceptions and Exclusions to C.O.D. Taxation

Per the IRS, exceptions to C.O.D. taxation include, but are not limited to: gifts or bequests and cancellation of certain student loans. Additionally, debt cancelled by a bankruptcy is excluded from C.O.D. taxation.

For more information regarding whether you might be impacted by cancellation of debt taxation, consult an accountant or real estate attorney in your area.

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