Forgiven or canceled debt is always taxable, but the party responsible for paying it depends on the circumstances. Generally, only debt forgiven by commercial lenders result in an increased tax burden to the person who owed money. This situation is generally not applicable in a case where debt is canceled due to death. The more likely scenario is that the debt was forgiven in the decedent's will, or a beneficiary of the estate who received the debt forgave it. In these cases the holder of the debt will have to pay tax, either through the estate tax or gift tax.
Forgiven debt is taxable for the individual who owed money when the debt holder is a commercial lender, such as a bank. The amount you report on taxes is the amount of debt outstanding when you paid the debt. So if you borrowed $100,000 and paid back $20,000 prior to the cancellation, you would have $80,000 in reportable income. If the debt was forgiven due to the debtor being bankrupt or insolvent, the forgiven debt is not taxable. However, future tax deductions and the basis of assets must be decreased so that the debtor will have to pay more taxes in the future.
The estate tax is a federal tax on the property a decedent owned and has the right to provide to beneficiaries after their death. The estate is made up of property in which the decedent had an ownership interest. This would include money he was owed. Regardless of whether the debt is terminated after the decedent's death, the estate will have to include the debt in the gross estate. The only way for the debt to be terminated after death, absent some contingency in the debt instrument, is through the decedent's will. A will is the written record of the deceased's desires as to how his property is to be distributed. If the will does absolve the debtor from repaying the debt, the debtor will not have to report the income on his personal return.
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If the debt is transferred by the decedent in his will to a third party and then that party forgives the loan, the forgiving party generally must pay gift tax. A gift tax is a levy on all transactions where a party receives property without paying full price, and the motivation for the transaction was a donative intent. The tax is assessed on the person who donates the property; the person who receives the gift is charged nothing. Only gifts to an individual in excess of $13,000, or $26,000 if given by a married couple, are taxable. If a debt is forgiven, it would be considered a gift because full consideration for the obligation was not received in exchange for the absolution of the debt.
If you are an executor of an estate, consult with a licensed attorney in your area to ensure that you comply with all state laws regarding the distribution of the estate's property. When completing personal, estate, or gift tax returns, consult with a certified public accountant (CPA) to ensure that the returns are appropriately filed. While every effort has been taken to ensure that this article's completeness and accuracy, it is not intended to be legal advice.