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The forgiveness of a legal obligation, in whole or in part. In real estate, it occurs most frequently when a mortgage lender agrees to accept a deed to the property rather than go through a foreclosure, and further agrees to accept the property as full payment for the loan, even though it is not worth the full amount of the loan.In such a situation the borrower has received debt relief and must report that as income for tax purposes. There is a loophole: if the debtor was insolvent immediately before the debt relief, and insolvent immediately after the debt relief, then he or she need not declare income to the extent of the insolvency.
The debtor owes $125,000 on his home and 20,000 on credit cards. The debtor's only asset is his home, which is worth $110,000.
Netting assets and liabilities before the debt relief results in the debtor being insolvent by $35,000. After giving the home to the bank and receiving forgiveness of the balance of the mortgage loan, the debtor now still has credit card debt of $20,000 and no assets at all. The debtor is insolvent by $20,000.
Because the debtor is still insolvent, and the debt relief did not cure his condition of insolvency, there is no taxable income.
See also Publication 17, “Your Federal Income Tax,” Chapter 12, “Other Income,” available at the IRS Web site, www.irs.gov.