Discharge (or Cancellation) of Debt (Part 1 of 4)

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Discharge (or Cancellation) of Debt (Part 1 of 4)

Arlington Heights bankruptcy attorney explains that when a borrower receives money in a loan transaction and the borrower does not pay the debt, the borrower’s wealth is deemed to have increased. 

This is known as “Discharge of Debt” or “Cancellation of Debt.” Because a “Discharge of Debt” increases the debtor’s wealth, the Internal Revenue Code (IRC) § 61 (a)(12) specifically includes this as gross income of the taxpayer.

However, IRC §108 provides five exceptions to § 61 (a)(12), under which a taxpayer may be excused from recognizing the discharge as gross income. We will only be addressing exception #1 in this newsletter; the remaining 4 will be addressed in the newsletter entitled, “Discharge of Debt, Part 4 of 4.

1.  Discharge of Qualified Principal Residence.  Under the Mortgage Debt Forgiveness Relief Act of 2007, a taxpayer may exclude from gross income and thus Federal income tax, the amount of mortgage debt that is reduced through short sales, mortgage modifications, and foreclosure.

            In order to qualify for the exclusion from Federal income taxes under the Mortgage Debt Forgiveness Relief Act of 2007, the following conditions must be met:

1. The debt (that is forgiven, discharged, or cancelled) must only be from commercial lenders loaned between January 1, 2007 and December 21, 2013 for qualified principal residences;

2. Up to $2 million of debt is eligible, or up to $1 million of debt if married and filing separately;

3. The debt forgiven only applies if derived from the short sale, mortgage modification, and/or foreclosure of a qualified principal residence;

4. The debt forgiven is for the first and/or second mortgage of a qualified principal residence;

5.  The taxpayer must file IRS Form 982 with the taxpayer’s tax returns, which states the amount of debt forgiven and it must be done in the tax year the debt is forgiven (VERY IMPORTANT!);

6.  The Act only applies to the “qualified principal residence.” This is a house that the taxpayer has owned and used as the taxpayer’s principal residence for a period of two or more years ending on the “identifiable event,” which means the event that determines when the debt was cancelled, reduced or forgiven, and the nature and timing of this event of each case.

For any questions or concerns, please feel free to contact the law office of Arlington Heights attorney Robert S. Thomas.  To read Discharge of Debt part two, three or four click on each link.