Untaxable Canceled DebtAs you might have already understood from the “Tax Consequences of the Debt Settlement” article, the canceled part of the settled debt in usually regarded as a part of the debtor’s taxable income. However, there are certain exceptions from this rule as well. This article lists the debts that do not require you to pay income taxes in case some part of them gets canceled. So, you will not be subject to paying out the debt relief tax if your canceled debt belongs to any of the following types:
1) Nonrecourse debt If you are not liable for the debt you are currently trying to settle (nonrecourse debt), you might not have to pay taxes on the canceled part of it. Nonrecourse debt is usually attached to some property – and can be canceled partially or fully in case this property is foreclosed or repossessed. This may result either in a gain or a loss for you (you can learn more about the tax consequences of settling a nonrecourse debt from Publication 544).
2) Student loans Most student loans get canceled in case a college/university graduate who has received the loan agrees to work in his/her profession for a certain period of time for any of the approved employers. In case it happens, the canceled student loan is not regarded as taxable income by IRS. However, this rule applies only to the loans given by any of the following:
(1) federal, sate or local government, or any of their subdivisions, agencies or instrumentalities;
(2) a public benefit organization (untaxable) that is in charge of some municipal, country or state hospital and which is staffed with people considered to be public employees under state law;
(3) educational institution.
However, there are certain limitations applicable to student loans given by educational institutions, namely:
- the debt relief tax doesn’t apply to a canceled student loan issued by an educational institution if the funds for the loan were provided by any of the entities stated above under numbers (1) and (2);
- the debt relief tax doesn’t apply to a canceled student loan issued by an educational institution as a part of the program aimed at encouraging the students willing to work in professions or geographic locations with unmet labor needs.
3) Deductible debt The debt relief tax doesn’t apply to the cancellation of a debt in case the debtor’s payment would be deductible. However, this exception may apply to you only in case you are using cash in your accounting.
4) The debt for an item, the price of which was reduced after the purchase If the price of a property that you have purchased on credit gets reduced, the debt relief tax will not apply to the part of your debt canceled by the seller. In this case the reduction of the outstanding debt should be treated as a plain adjustment of the price for the purchased item.
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