Paying up debts can be challenging for one, especially when they pile up and the financial position of the borrower is crippled. Sometimes, the lenders are willing to forgive the debts, giving the financially challenged borrowers some relief. As much as this helps the borrower, it can also trigger some negative tax consequences, or not.

Is Cancellation Of Debt Income (COD) Taxable?

Yes it is!  When a lender forgives part or all of your debt, it results in cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs. 

However, there are a number of exceptions to the general rule that COD income is taxable. These exceptions can be found in Section 108 of the Internal Revenue Code, and they are generally mandatory rather than elective. The two common exceptions are:

• Bankruptcy 
• Insolvency

The cost of being allowed to exclude COD income from taxation under the bankruptcy or insolvency exception is a reduction of your tax attributes (as a borrower). 

You generally reduce these future tax benefits by one dollar for each dollar of excluded COD income. But you reduce tax credits by one dollar for each three dollars of excluded COD income. You reduce these attributes only after calculating your taxable income for the year the debt cancellation occurs. These are reduced in the order below;

• Net operating losses 
• General business credits 
• Minimum tax credits
• Capital loss carryovers
• Tax basis of property
• Passive activity losses and credits
• Foreign tax credits

As mentioned above, any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.

Principal Residence Mortgage Debt Exception

A temporary exception was created for COD income from qualifying cancellations of home mortgage debts occurring through 2025. The current rules of the exception allow a borrower to have up to $750,000 of federal-income-tax-free COD income. 

Alternatively, if the borrower uses married-filing-separately status, they can have up to $375,000, from the cancellation of qualified principal residence indebtedness. This is debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.

COD works like a two-edged sword, helps you out of the debt mess but can also cause some negative implications on your taxes. Well now, you are in the know.  If you have any questions or need to discuss this further, please, reach out.