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Debt Forgiveness – What are the Tax Consequences?

Tax season is fast approaching and many people have questions regarding the tax impact of debt forgiveness. During our recent real estate boom many pe...

 

Tax season is fast approaching and many people have questions regarding the tax impact of debt forgiveness. During our recent real estate boom many people overextended themselves and their homes were forced into foreclosure. The next step is determining whether or not they will have a resulting tax liability.

Whether or not the taxpayer will have debt forgiveness income depends first on whether the mortgage debt is recourse or nonrecourse. Debt is considered recourse if the taxpayer is personally liable for the indebtedness. Under a recourse debt instrument, once the property is disposed of and the lender agrees to forgive the remaining debt balance, income from cancellation of debt must be analyzed.

Debt is generally considered nonrecourse if the property itself is the only collateral for the loan and the lender does not have the ability to pursue a deficiency against the taxpayer. For a nonrecourse debt instrument, the lender only has the ability to take the property back so there is no occurrence of debt cancellation.

Even though nonrecourse instruments do not result in income from debt forgiveness, the taxpayer must still determine whether not there was a gain on the disposition of the property. Depending on the situation, the homeowner could find themselves owing capital gains tax as a result of foreclosure.

Now just because your debt is recourse does not mean that you automatically have a tax problem. Generally, debt forgiveness is taxable. But there are many exclusions that you may qualify for depending on your situation.

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