Cancellation of Debt Part One: Tax Consequences on the Horizon

6/8/2017 - By John Mascaro, CPA

So, after several months of wrangling, testy email exchanges and awkward personal meetings where you’ve dragged along your attorney and CPA, that creditor who by now has become a household name (banker, or seller who took back a purchase money mortgage, or the credit card company, etc) agrees to forgive and formally cancel some or all of the debt you owe them, an issue that has been a thorn in your side for over a year.  

Your first reaction is to jump for joy, call the spouse, and plan a celebratory dinner - of course.  And that may be an understandable first reaction – after all you will not have to deal with the burdensome principal and interest payments, no more harassing emails, letters and phone calls, you can stop chugging that Pepto-Bismol® at lunch, and finally get to do something your friends say is quite an enjoyable pastime – What’s that they call it? - Oh yeah, sleep.

Not so fast.

You see, when a loan that you owe is forgiven and canceled, the amount canceled can have rather surprising tax consequences. The tax law often refers to this forgiveness as a “discharge” of debt – which almost makes it sound like a medical condition!  

The tax law considers you to have received “income” to the extent of the amount you will no longer have to repay. 

Ouch!  The justification for this treatment stems from the fact that presumably you’ve used the proceeds from the loan to obtain an economic benefit, including a tax benefit by way of a capitalized cost that is being amortized or depreciated as an expense over time. You might also have obtained a currently deductible expense, or the funds have become part of the cost of property that may offset some portion of any future gain when that property is sold.  

Therefore, if a lender who provided the funds later forgives your requirement to repay them, the canceled debt is now considered “income” to you at the time of such cancellation. This canceled “debt” includes not just the principal amount outstanding on your loan, but also accumulated interest.

As you might have figured out by now, you are not receiving any additional cash for this “income” (in effect, the cash already came to you by way of the earlier loaned proceeds). 

This is why cancellation of debt – or C.O.D. income - is sometimes called “phantom income."

Because such income must be included in arriving at the computation of your taxable income, unless you have other deductions to offset this phantom income, it will be wholly subject to tax at your effective tax rate for the year.  

If you have any questions about canceled debt for you or your business, email me or contact a member of our Tax Consulting team today. We look forward to advising you on this and any other tax issue you may have.   - Part 2 Coming Soon!

About the Author | John Mascaro, CPA

John is adept in helping companies develop and execute complex domestic and international tax strategies. He has served some of the world’s largest companies in varied industries, including IBM, Schlumberger, Siemens; and later specialized in the entertainment and media industry serving such notables as Viacom, Blockbuster Entertainment, MTV, VH1, Nickelodeon, SONY Pictures, SONY Music, Newsweek Magazine, McCann Erickson Advertising, Gruner & Jahr Publishing, Reuters and numerous entertainment and media celebrities.

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