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Know How to Handle Canceled Debt

Borrowing money comes with a legal obligation to repay what is borrowed plus interest.  But what happens when part of the debt is forgiven? After the initial relief of not having to repay the full amount of the debt, you come to realize that you still do owe something. The amount of the canceled debt is taxable, and you must report it on your tax return for the year the debt was discharged.

But there are subtleties. If you used property to secure your debt, the amount realized is the fair market value (FMV) of the property. Your ordinary income from the cancellation of the debt is the amount of the debt beyond the FMV that the lender forgives.

If your property was subject to a nonrecourse debt, you must realize the entire amount plus the FMV of any property you received. You won’t have ordinary income from the cancellation of the debt.

Other exceptions may include:

Amounts that meet the requirements for any of the following exclusions aren’t included in income, even though they’re canceled debt income:

If you exclude canceled debt from income under one of the exclusions listed above, you must reduce certain tax attributes — credits and carryovers, losses and carryovers, and basis of assets by the amount excluded.

It can get complicated, and it doesn’t help that rules in this area change: A “break” available one year may not be available the next. Basically, if you had debt forgiven, wiped out or negotiated away last year, you may owe income taxes on the amount of debt erased, and you need to discuss it with a financial professional. If a debt of $600 or more is forgiven or canceled, the IRS requires the creditor to issue a 1099-C tax form to you to show the amount of debt not paid. Be sure to have that form in hand when you speak with your tax preparer.

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