Cancellation of Debt, Foreclosures, And Bankruptcy – Part 2

What is Cancellation of Debt?

Cancellation of debt is the release from collection activity on a debt by a lender without consideration from the debtor. In other words, the person or institution you borrowed money from releases you from the responsibility to repay that debt. Normally, if you have the use of money, that you are now not obligated to repay, it must be treated as income. There are lots of exceptions and exclusions to that statement and we will review many of them.

As with most things in taxes, you must move through this subject in a specific order and not jump around. You must make certain determinations in a specific order to see how much, if any, taxable income your client will have to include on their tax return.

A debtor may be subject to either voluntary or involuntary cancellation of debt. In a voluntary situation a debtor works with the debt company to restructure their debt and usually only part of the debt is canceled (normally accrued interest and/or penalties).

In an involuntary situation, normally, the debtor simply stops making payments and ignores contact attempts from the creditor. The creditor eventually either sells the debt to a collection agency or cancels the debt as noncollectable.

The amount of debt that is written off by the creditor, either voluntarily or involuntarily, is considered CODI. We will discuss the taxable determination of CODI later.

What if there is collateral involved?

When cancellation of debt involves secured debt the collateral will normally be seized in payment for part or all of the debt. The seizure can, again, be voluntary or involuntary and the seizure of the property must be treated by the debtor as a deemed sale of the property.

The debtor may voluntarily surrender a piece of collateral property to the creditor when the threat of foreclosure or repossession is imminent. This will usually cost the debtor less in the long run as the creditor will not have to go through all the legal proceedings to do a formal foreclosure or repossession.

A debtor my also abandon the property; that is, voluntarily and permanently give up possession and use of the property with the intention of ending ownership but not actually transferring that ownership to another party.

This will usually cost the debtor more in the long run as the creditor must wait out the time frame specified by the state and than do formal foreclosure or abandonment proceedings. On the other hand it also gives the debtor more time before those proceedings take effect.

The final course of action is for the creditor to actually proceed with foreclosure and/or repossession actions while the debtor still has use and possession of the property. The creditor will add the costs to the loan and the debtor must start making payments on the loan again, but the debtor gets to keep their collateral.

This is usually the middle ground between the first two options and, if the debtor is trying to restructure the loan, may give the debtor time to get this done before the foreclosure and/or repossession is completed.

When talking about real property as the collateral for the debt, many times the debtor will be able to restructure the loan, keep possession of the home, and still have some CODI. It is important that just because a client has documentation showing CODI on a piece of real property you do not assume they “lost” the house.

Next:  Part 3, How Do I know if my Client has CODI?

Anything and everything taxes. I also write the Louisiana State book to go to our new Income Tax Course learners and the state-wide training for upper level Tax Professionals. I am an Instructor of all levels of tax related classes. I love to teach and write as well as taking the absolute best care of my clients all year round.

26 years in Law Enforcement (13 in the Air Force and 13 at the Bossier City PD), 20 years doing income taxes professionally.
My goals now are to spend many years being my 3 grandchildren’s MeeMaw, taking the absolute best care of my clients, and continually learning new things.
Specialties
Taxes! I specialize in military, states, small business, and rentals.
The postings made on this site are my own and do not necessarily represent HR Block’s positions, strategies or opinions.

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