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Typical situation: An individual owes money to a third party relating to a loan for business or personal reasons. Due to extenuating circumstances, the lender agrees to a settlement of an amount less than the amount the borrower owes in principal and interest. So the full amount of debt is effectively wiped off the books.

Case closed … right? Not exactly. The individual still faces potential federal income tax liability when a debt is completely or partially forgiven. In other words, you must pay tax on the reduction of the debt you benefit from. This is commonly referred to as cancellation of debt (COD) income in tax circles.

Background: If a debt is forgiven or canceled, the benefactor must report the amount as taxable income on his or her personal tax return. A business debt is reported on the appropriate return for the business entity or sole proprietorship. For this purpose, a debt includes any indebtedness for which the party is legally liable or indebtedness that attaches to property owned by that party.

Similarly, the debtor is required to report any interest attributable to the debt that is being forgiven or canceled. It’s a double whammy.

New case: A taxpayer who attended college in the 1980s borrowed money from the Connecticut Student Loan Foundation (CSLF) to help pay for school. At some point, the taxpayer became delinquent in the payments. Eventually, he settled the debt with CSLF by paying $45,000 of the $73,000 he owed, at a discount of $28,000. Result: The Tax Court says the taxpayer now owes tax on $28,000 of COD income.

Be aware, however, that there are several key exemptions to the rules for COD income, including student loans requiring the student to work after school for a specified time in a designated profession and certain student loans issued by tax-exempt organizations. Also, COD income does not have to be realized if the payment of debt would have been tax-deductible. (This exemption only applies if the cash method of accounting is used.)

Furthermore, the rules for tax on COD income generally do not apply to insolvent taxpayers or those in bankruptcy proceedings. Other special rules apply to indebtedness of farms.

Finally, there is a specific exclusion from COD income for debt of a principal residence. The exemption, which was established by a recent tax law in the wake of the mortgage foreclosure crisis, is capped at $2 million of qualified principal residence debt. Technically, this tax break is currently scheduled to expire for debts discharged after 2012.

Final words: Do not simply assume you are in the clear. Talk to a Condley and Company, L.L.P.  professional regarding the tax consequences of debt forgiveness or cancellation.