Almost every American has a debt story to tell. From house mortgage to student loans, people are sometimes faced with many different debt obligations at once. While each person’s debt obligations may vary, paying off debt is not only a moral responsibility but also a legal one. However, the financial situation of a person may change with time and there might come a time when the borrower can no longer pay back the amount due. In such a situation, the lender might move forward to cancel the debt.
Cancellation of Debt
The amount of debt that has been forgiven by the lender is expected to have tax consequences. This forgiven debt must be made a part of the gross income of the borrower in the year when it is discharged. However, there are some exceptional cases in which this forgiven amount is not seen as cancelled debt.
In case of property, the cancellation of debt might also include foreclosure or repossession of the house. Once the debt is cancelled, the lender is required to fill in the Form 1099-C, which will have all the details about the amount that has been cancelled. It is your responsibility as a borrower to make sure that everything mentioned on the form is accurate. Also, once you receive such a form from the lender, your debt obligation comes to a halt and therefore, you are not required to make more payments to the lender.
After the debt has been cancelled, it is your duty to report this taxable amount when filing your tax returns. This cancelled amount is mentioned on Line 21 depicting ‘other income’ on the Form 1040. However, it is important to verify whether the amount that has been forgiven is indeed cancelled debt or not. Cancelled debt will be considered to be taxable income if:
The cancelled amount of your debt will not always be considered taxable. Here are the scenarios in which a cancelled debt is free of any tax consequences:
The bank or any other lending institution may decide to keep the property as a result of your failure to pay off the debt. In such cases however, the debt remains to be your personal responsibility and there are tax implications that you must face. However, whether you owe a specific amount or not depends on the kind of loan that you had applied for in the first place.
Recourse or Nonrecourse
When you are purchasing a property, the documents associated with the purchase explicitly mention whether the loan is considered a recourse loan or a nonrecourse one. The difference between these two types is pretty simple but necessary to understand. In case of a recourse loan, if the original price of the property was higher than the amount of loan payments you have paid out, you are held responsible for the shortage.
This shortage has to be compensated by you and the lending institution automatically earns the right to repossess the property or use your business assets as compensation. Thus, if the documents reflect the purchase of the house with the help of a recourse loan, you will be held responsible and will be eligible for voluntary handing over of the property or repossession.
On the contrary, in case of a nonrecourse loan, the one buying the house is not held responsible for any shortage that occurs and there is nothing that the lender can do about the outstanding balance for the loan. Such a loan favors the borrower and avoids any problems that might arise as a result of their failure to make payments.
Repossession is considered to be a sale in both types of loans. The property is first valued at a fair market rate and the amount that comes out is then used for determining the tax implications. In a recourse debt, the gain or loss is recorded and any amount forgiven by the lender is taken as a part of the gross income. In the case of a nonrecourse loan, the borrower does not have any obligation associated with the remaining balance and since there is no amount to forgive, there are no tax implications.
Understanding the tax implications of a failure to pay off debt is necessary. While it is strongly recommended to pay off any debt that you owe, if you are unable to do so it is advised to take the above mentioned points into consideration.