The economic conditions of the last few years have caused many taxpayers to restructure mortgages and/or credit card obligations resulting in cancellation of debt income.  This article discusses the treatment of such income.

Are there any tax ramifications to mortgage debt forgiveness?

Normally canceled debt is considered taxable income; however there are certain exceptions to the general rule.   One such exception is for discharge of qualified principal residence indebtedness.  The debt cancellation can be the result of a mortgage loan modification or a foreclosure.

Qualified principal residence indebtedness is debt incurred in acquiring, constructing or substantially improving your principal residence which is secured by your principal residence. It also includes debt secured by your principal residence that refinances debt incurred to acquire, construct or substantially improve your residence.  Any portion of a refinancing not used for the aforementioned purposes, such as using proceeds to pay credit card debt or take a vacation, would be includable in income unless another exception applies.

Are there any tax ramifications to credit card debt forgiveness?

As mentioned above cancelled debt normally results in taxable income.  There are two exceptions to this rule which may allow a taxpayer to exclude cancellation of debt income arising from a restructuring of a credit card agreement from his/her tax return.

The first exception is bankruptcy.  If the credit card debt was cancelled as part of a bankruptcy proceeding, then the income (forgiven amount) is not considered taxable income.

The second exception relates to debts discharged while you are insolvent.   The definition of insolvency is when the fair market value (FMV) of a taxpayer’s liabilities exceeds the FMV of his/her assets.  If this is the case, then the income is not considered taxable income.

Are there any other exceptions to the cancellation of debt rule?

There are certain exceptions for cancellation of student loans when an individual works for a period of time in certain geographical areas or certain professions.  This may relate to teaching in inner-city school systems or practicing law or medicine in rural areas.

One more exception that I have seen a number of times is forgiveness of business real estate debt.  The debt must be acquisition debt. Acquisition debt has the same definition as the principal residence debt discussed above.  The amount of the loan forgiven is excluded from income; however, it reduces the basis of the property owned by the taxpayer, thereby increasing the taxpayer’s gain upon its sale.  The excluded or deferred amount, of taxable income cannot exceed the taxpayer’s basis in the property.

Conclusion

This article explains some basic concepts regarding the exceptions to the cancellation of debt income rules.  There are several other exceptions and there are very stringent rules which need to be adhered to in order to qualify for the exceptions listed in the article. As always I would encourage taxpayers to contact a tax professional that has knowledge of the appropriate laws and regulations.