What Are the Tax Consequences of a Cancelled Loan?

Everybody knows that income is subject to federal income taxes. Income means an increase in wealth. Thus, income includes the wages you earn from a job, interest you earn on savings and other investments, and the profit you earn by running a business.

But what if you borrow money? For example, what if you borrow $10,000 from your brother-in-law to start a business--is this taxable income? The short answer is "no." The loan has not increased your wealth because you're under a legal obligation to pay it back. You do not need to report the $10,000 as income on your tax return.

What happens if the person you borrowed the money from decides you don't have to pay it back? Here's where it gets tricky. The amount of a debt that is forgiven by the lender is income to the borrower because the borrower's wealth has been increased--he or she still has the money, but is no longer under any obligation to pay the loan back. Thus, even though no additional money comes into the borrower's hands, a forgiven debt is income. For example, if your brother-in-law decides you don't have to pay the $10,000 back, you'll have to add the money to your income for the year.

This rule has had enormous consequences in recent years because, due to the recession, real estate values fell drastically and many borrowers were unable to repay their home mortgages. Many homeowners had their mortgages modified or restructured, or went through a foreclosure, and their lenders ended up forgiving all or part of their home loans. Ordinarily, a homeowner who has all or part of his home loan forgiven by the lender would have taxable income. However, a special law was enacted in 2007 to prevent this from happening. Under the Mortgage Forgiveness Debt Relief Act of 2007, up to $2 million in forgiven debt on a taxpayer's principal residence is exempt from taxation. For details, see Cancelled Mortgage Debt: What Happens at Tax Time.

There are several other situations in which a forgiven debt is not taxable income. For example, if you file for bankruptcy and have your debts discharged by the bankruptcy court, you do not have taxable income. If this were not the case, there would be no point in filing for bankruptcy--you'd just be replacing one creditor with another.

A forgiven debt is also not taxable income if the lender forgives the debt as a gift to the borrower. Gifts are not taxable income (otherwise, you'd have to pay income tax on the value of your Christmas presents!).

You make a gift if you give property (including money), the use of property, or the right to receive income from property without expecting to receive something of at least equal value in return. If you sell something for less than its full value or if you make an interest-free or reduced interest loan, you may be making a gift. Thus, for example, if your brother-in-law forgives your $10,000 loan purely because he wants to help you get started in business, and he receives nothing of economikc value from you in return, it may constitute a gift.

Corporations cannot make gifts, only people can. (This is one instance where a corporation is not a person.)

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