An issue that can still have tax ramifications today, years after the great recession hit Reno, is that of debt forgiveness. If you think that since you never received any cash, debt forgiveness is not taxable, think again!
Whenever there is a loan balance that gets reduced in any way, either with debt forgiveness, a foreclosure, a short sale, or a cancellation of debt, there is a taxable event. Depending on whether the debt held was recourse or nonrecourse makes a difference as to whether the forgiveness will be classified as cancellation of debt income or a capital gain.
A taxpayer wants cancellation of debt income when they are either insolvent, the home is their principal residence or they are in bankruptcy. In these situations the income is excluded from taxable income. If these situations don’t apply then the debtor wants a capital gain. In this instance the gain will be taxed at lower rates and if they have any capital losses then the gain can be reduced by these losses.
Generally, if a loan is nonrecourse and the property backing the loan is foreclosed upon to satisfy the nonrecourse debt, then the excess of the debt over the tax basis of the property is a gain. However, if the lender merely reduces the principal of the nonrecourse debt, then cancellation of debt income occurs.
The rules are different for recourse debt. If there is a foreclosure of property to satisfy recourse debt than the taxpayer recognizes cancellation of debt income by the difference between the fair market value of the debt versus the debt discharged. The difference in the fair market value versus the tax basis is then recorded as a gain or loss.
This brief summary just hits the surface of the complex rules regarding debt forgiveness. When this situation occurs, consult a Reno CPA to figure out the tax consequences.