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Tax Consequences of Debt

Bad Debt Expense Deduction

If you lend money without imposing interest, there are no tax consequences that result from the transaction. The IRS treats interest-free lending similarly to making a gift where the lender bears all risk and is unable to deduct any payments the debtor defaults on. However, if you charge interest on the loan, the tax laws treat the interest payments as taxable income. You must report all interest payments you receive during the tax year on your personal tax return. The same principle applies when you deposit money into an interest-bearing savings account at your bank. Generally, the bank will provide you with a statement each year that reports the total interest payments it deposits into your account which you must report as income on a tax return.

Student Loan Interest Deduction

In some cases, the borrower who makes the interest payments on a loan receives a tax deduction. A common example is the interest that graduates pay on the repayment of student loans. To qualify for this deduction, you must only use the loan funds to pay tuition and fees, to purchase books and to obtain room and board. If you use any portion of the loan for expenditures that do not relate to pursuing your education, the interest that accrues on that portion does not qualify for the deduction.

Assumption of Debt

The federal tax regulations often treat debtors who transfer a debt obligation to another taxpayer as receiving taxable income in an amount equal to the outstanding debt. This commonly occurs in the context of a home sale where the buyer assumes responsibility for the remaining mortgage balance. In this situation, the IRS requires the seller to include all debt assumptions in the purchase price they receive for the home. For example, if you sell your home that has a $50,000 outstanding mortgage balance and the buyer agrees to assume the mortgage plus pay you $200,000 in cash, then you must use a sales price of $250,000 when calculating gain on the sale of your home.

Cancelled Debt

Similar to an assumption of debt, you must recognize taxable income when a creditor decides to cancel your debt and reports it on a 1099-C. A legal cancellation of debt requires the creditor to release you of any obligation to pay the outstanding balance. However, a cancellation of debt does not occur just because a company writes the receivable off its books and forwards the debt to a collection agency. In this scenario, you still have a legal obligation to pay the collection agency. This income rule applies to all forms of debt, regardless of the type of property you purchase with the borrowed funds, unless an exception applies, such as with foreclosures.

IRS Reference: Topic 430 – Canceled Debt