Question

Ralph has experienced financial difficulties as a result of his struggling business. He has been behind on his mortgage payments for the last six months. The mortgage holder, who is a friend of Ralph's, has offered to accept $80,000 in full payment of the $100,000 owed on the mortgage and payable over the next 10 years. The interest rate of the mortgage is 7%, and the market rate is now 8%.
Required:
What tax issues are raised by the creditor's offer?

Answer 1

Answer: Recognition of $20,000 gain in income.

Explanation:

The creditor reduced the mortgage that Ralph would have to pay by $20,000 because Ralph was struggling to keep up payments. When debt is reduced, the reduction is usually taxable because it is treated as income.

The reason for the reduction of debt is not a reason for a debt reduction being exempt from taxation so the $20,000 will have to be treated as a gain and will be reported as such for Ralph's gross income.