Cancellation of Debt

If you just had your debt canceled by your creditor, no doubt you yippie!-ed with great abandon. Getting debt canceled in an economy where most people do not even get debt facilities is pure amazing. But while you may continue prancing around your house, you will sooner or later need to sit yourself down in your house and look for how to deal with the tax liability.

Handling a Canceled Debt

It is a rare enough case alright. Where do you find debtors these days that readily waive off your debts? Hard to say really. But when a debt does get canceled, you need to look at the tax repercussions of the thing just to be sure.

Because, when you received the financing as a form of debt, you happily conceded that this not being so much a source of income rather than an olive branch for survival, you need not pay tax on. Because, technically since you need to return it to the lender, it's not really an income and hence the debt excuses itself from the mire of payroll taxes.

But when this debt is canceled, it creates what is known as the cancellation of debt income. So now if your creditor in his large-heartedness chooses to cancel your debt, he basically withdraws his right to claim the money. Which means you need not pay the creditor back. Which means that the debt, isn't quite a debt, but an income, which you used and expended. Which means it needs to be taxed. Taxes of course are paid on your income and since canceled debt amounts to income, you will have to pay a tax on it.

You simply write off the debt and it adds to your annual income. You then calculate what tax bracket you fall under for payment of income tax, post addition of this canceled debt and then pay up accordingly.

Exceptions to the Rule

Not always is a canceled debt a tax liability. Here are the cases where cancellation of debt doesn't attract a tax payment.

• Bankruptcy: Well, it's only fair that you are not asked to pay tax when you've lost pretty much ever asset you had, at the end of the bankruptcy proceedings. So, yes, debts canceled in the process of bankruptcy are not taxed.
• Insolvency: You're an insolvent when your debt exceeds the amount of assets you own and most debts canceled during insolvency are not taxed.
• Student Loans: In a case where your student loan is forgiven by your tax-exempt institution and you have been working for a qualified employer as per the IRS rules, your debt is not taxed.

So this was all about cancellation of debt. Debt cancellation is rare and happens in 3 basic cases. 1) If the period for statute of limitations on debt has expired. 2) The lenders agrees to cancel the debt. 3) The lender's business policy disallows him to pursue collection of debts which are more than 2-3 years old. Either way, even if you have to pay a tax on the amount, it is still a winning deal for you as you get a lot of money out of it!