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Income tax exemption and liability is complex for cancelled debt

In one of our recent posts we discussed the impact that forgiven credit card debt can have on federal income taxes. With tax season approaching and many Tennessee readers in the process of preparing their tax return, it is important to take into account the variety of ways that debt consolidation or debt forgiveness can impact a tax return.

As we discussed previously, some types of forgiven debt are considered to be income for tax purposes, which means that the amount that was discharged in a bankruptcy proceeding or through other means are reported on a specific tax form for cancelled debt and is taxable in full. On the other hand, the Mortgage Forgiveness Debt Relief Act provides an exemption for cancelled debt on a primary residence.

The law, which was extended at the last moments during the fiscal cliff negotiations towards the end of the last year, allows homeowners who sell their home in a short sale or who are evicted from their homes in a foreclosure proceeding. The law allows homeowners to avoid taxes on as much as $2 million in forgiven mortgage debt.

For people with cancelled debt that is not tax-exempt, it can be very difficult to suddenly come up with the funds to pay the tax bill, since an inability to pay for the debt was the reason it was discharged to begin with. This is why it is so important to know whether or not each specific cancelled debt qualifies under an exemption or not. One commonly overlooked exemption is debt that was forgiven due to insolvency, which can include credit card debt when the total amount of debt exceeded the borrower's assets.

Source: CBS Money Watch, "What taxpayers should know about cancelled debt," March 12, 2013.

More information about debt relief can be found on our Memphis bankruptcy site.

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