If you’re going to go through bankruptcy or to look for other methods of having debt cancelled, it’s important to know how your taxes are affected by that decision. When a lender cancels any part of your debt, that debt becomes income in most cases. What that means is that you are expected to pay tax on that income, just like you would on income from a job.
There are some exceptions that you should know, though. Here are three to think about as you look into canceling out your debts.
- Your main home’s value could be excluded
The first thing to know is that if your main home’s loan was cancelled or a portion of that debt was eliminated, then you may be able exclude that debt forgiveness from your income. To do this, you’ll need to show that the loan was used to improve your main home, build your main home or buy your main home.
- Tax laws exclude some refinanced mortgages
In some cases, the tax laws exclude a portion of refinanced mortgages when those debts are forgiven. Again, you will have to show that you have built, bought or improved your main home up to the value of the original mortgage principal before the refinancing took place. If you can show that, then any amount used for that purpose may qualify.
- You can sometimes exclude loan modifications
Finally, you can sometimes exclude loan modifications. It’s possible to exclude debt discharged in the Home Affordable Modification Program or through foreclosure in some cases.
What can you do about forgiven debts in other forms?
It may be possible to have certain debts forgiven, such as credit card debts or debt from second home purchases, but most of those will not fall under exclusions and will be treated as income. There are some exceptions in certain categories on a person-by-person basis that you should look into with the help of your attorney. In some cases, debt exclusion could reduce your taxable income by thousands of dollars, preventing a large tax bill from the debt forgiveness that was granted.