When Cancellation of Debt (COD) Income Can Be Tax-Free

Sometimes debts can pile up beyond a borrower’s ability to repay, especially if we are heading into a recession.

But lenders are sometimes willing to cancel (forgive) debts that are owed by financially challenged borrowers.

While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event.

General Rule: COD Income Is Taxable

When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs.

Fortunately, there are a number of exceptions to the general rule that Cancellation of Debt income is taxable. You can find the exceptions in Section 108 of our beloved Internal Revenue Code, and they are generally mandatory rather than elective. The two common exceptions are:

• Bankruptcy
• Insolvency

The cost of being allowed to exclude Cancellation of Debt income from taxation under the bankruptcy or insolvency exception is a reduction of the borrower’s so-called tax attributes.

You generally reduce these tax attributes (future tax benefits) by one dollar for each dollar of excluded Cancellation of Debt income. But you reduce tax credits by one dollar for every three dollars of excluded COD income. You reduce these attributes only after calculating your taxable income for the year the debt cancellation occurs, and you reduce them in the following order:

1. Net operating losses
2. General business credits
3. Minimum tax credits
4. Capital loss carryovers
5. Tax basis of property
6. Passive activity losses and credits
7. Foreign tax credits

As mentioned above, any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.

This taxpayer-friendly rule allows the borrower to take full advantage of any tax attributes available for the year of the debt cancellation before those attributes are reduced.

Principal Residence Mortgage Debt Exception

A temporary exception created years ago and then repeatedly extended by Congress applies to Cancellation of Debt income from qualifying cancellations of home mortgage debts that occur through 2025.

Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free Cancellation of Debt income—or $375,000 if the borrower uses married-filing-separately status—from the cancellation of qualified principal residence indebtedness. That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.

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