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Canceled debt is debt forgiven by lender

May 13, 2011

Q: My husband and I have been trying to keep up with our bills and pay our mortgage.There is a chance that our mortgage lender will work with us on reducing the payment and even lower the amount we owe. My sister says that this is "canceled debt" and we will have to pay tax on the amount forgiven. Can that be right?

A: Any debt for which you were personally liable that is canceled or forgiven by the lender is considered canceled debt. Discounts and Loan Modifications are changes to the terms of a current loan agreement by the lender. These changes could be a reduction in the original amount owed or even a special discount for paying off a loan early. That would be canceled debt also.

Unfortunately, under these scenarios, you would have "forgiven debt" that is considered by the IRS as 1099-C Cancelation of Debt (COD) windfall income.

Both forgiven debt and loan modifications generally result in 1099-C taxable income. However,there are exclusions.

Debt canceled on your "main" home is not included in your income if you are married and the amount of canceled debt is less than $2,000,000. This is called Qualified Principal Residence Indebtedness.

Also, you can elect to exclude canceled qualified real business indebtedness from income if the real property was used in a trade or business.

Insolvency is a third exception. If your liabilities owed were larger than your assets immediately before the cancelation, you are insolvent and do not need to include a debt in income.

Finally, debt canceled in a bankruptcy case is not included in your income.

Preparing a tax return with 1099-C income can be confusing and reporting exclusions even more confusing. You may want to seek the advice of an attorney who is experienced in the loan modifications that have become common in today's challenging economic climate.

Attorney Sylvia Heldreth is a certified specialist in real estate law. Her office is located at 1215 Miramar St., in Cape Coral.

This article is not intended as specific legal advice to anyone and is based upon facts that change from time to time. Individuals should seek legal counsel before acting upon any matter involving the law.



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