COD – Income from Cancellation of Debt

Generally, all income received from any source is included in a taxpayer’s gross income. Income is taxed as ordinary income unless the income is received from the sale or exchange of property characterized as a capital asset or from property used in a trade or business. When a debt for which a taxpayer is legally responsible is forgiven, the amount discharged is included in the gross income of the taxpayer. This is the case whenever any amount of debt is forgiven and is no longer the obligation of the taxpayer.

Unless an exception applies, the taxpayer must pay taxes on the amount of discharged debt even though they received nothing tangible to pay the tax with.

Exceptions include bankruptcy or insolvency of the taxpayer. If the forgiven debt is a business debt, the taxpayer’s tax attributes (net operating loss, general business carryover or basis in property) are reduced by any amount excluded from gross income. This prevents strategic use of a bankruptcy or insolvency to deduct both forgiven debt and net losses.

Another important exception is for ‘qualified principal residence’ indebtedness. Such indebtedness is limited to a mortgage secured by the taxpayer’s principal residence used to buy, build or substantially improve the home. This exception does not include home equity line of credit indebtedness.

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