Normally, when debt is cancelled it becomes taxable income to the debtor.  For example, if you borrow money that is evidenced by a promissory note or other document that obligates you to repay the debt at some future time, and all or part of the debt is cancelled, the amount that has been cancelled is treated as taxable income that you must report on your tax return for the year in which the cancellation occurs, and your creditor needs to file a Form 1099-C, Cancellation of Debt (https://www.irs.gov/pub/irs-pdf/f1099c.pdf).

Cancellation of debt can occur in several ways.  A creditor may, for whatever reason, agree that you do not have to pay then remaining outstanding balance.  Or the creditor is unable to collect the debt or even simply gives up trying to collect the debt.  If the debt is recourse debt that is secured, and the creditor realizes on the security, the amount of the debt cancelled will equal the amount of the outstanding debt at the time of realization minus the then-fair market value of the collateral securing debt.

However, the operative word at the beginning of this blog is “normally.”  There are exceptions to debt cancellation being treated as income to the debtor.  Bequests in a Will are one of those exceptions.  For example, it is not unusual for a parent to loan money to a child with low Applicable Federal Rate and a long amortization period.  If the parent dies prior to the payment in full of the debt and the parent’s Will provides that the debt in question is forgiven, then the amount of debt forgiveness is not considered taxable income of the debtor.

There are other examples of favorable treatment to the debtor upon the forgiveness of debt and a more in-depth discussion of this topic can be found at https://www.irs.gov/taxtopics/tc431.

Admittedly, unless you are a tax lawyer or CPA, the subject of taxes can be incomprehensible to the average reader.  Since I am neither a tax lawyer nor a CPA, I am among the many who find the subject taxing.  Forgiveness of debt, regardless of the circumstances, calls for competent tax advice.

This blog was authored by the team at Press, Dozier & Hamelburg

Press, Dozier & Hamelburg partners with businesses to achieve their goals, and represents families and individuals, often when they are most vulnerable. Our attorneys deliver valuable insight and counsel in the areas of business law, employment law, litigation, commercial real estate, estate planning and administration, and business succession planning. We provide all of our clients with personal service, emphasizing responsiveness, sensitivity, and respect. We are located in Bethesda and serve Maryland, Virginia and Washington, D.C. 

Note: The content in this Blog is for informational purposes only and should not be acted upon without first consulting legal counsel.  It is not intended to constitute legal advice.