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Q.What is Cancellation of Debt?
A.Both the IRS and California Franchise Tax Board treat cancelled debt as taxable income. Debt is cancelled when a lender gives up the right to collect the debt, or is barred by law from collecting the debt. If the debt cancelled was a "Purchase Money Loan," (a home loan used to buy a residential property that was used as a primary residence), the loan is considered a non-recourse loan. This is important because cancelled debt once owed under a non-recourse loan is afforded a different kind of treatment by the IRS. Although still treated as income, cancelled debt from a Purchase Money Loan is subject to the normal home owner exclusions ($250,000 for single and $500,000 for married couples). Thus if a married couple had a $300,000 purchase money loan cancelled, no tax would be due since it is less than the $500,000 exemption amount.
If, on the other hand, the cancelled debt originated from a loan procured for home improvement, a vacation home, a second home, investment property and the like, the borrower will owe income tax on the cancelled debt .
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