1. Making the obligations between the parties clear. Canceling the original
agreement or forgiving the loan would do this. The money doesn’t have to be
paid back. Both parties agree. Done.
2. Taxes. A loan isn’t income. But a loan being forgiven IS income. You said
these were small amounts, but they’ll still need to be reported somewhere
I’d bet. I think canceling the loan agreement would basically turn the loan
into a gift. Thus, it would be income for the recipient when it was
originally loaned out. If you forgive the loan, the income occurs on the
date of forgiveness. I think.
Maybe it doesn’t really matter, especially if the original loan and
forgiveness are occurring in the same tax year. But don’t forget about the
tax angle.
Upon the cancellation of the indebtedness, you have to look at the facts and circumstances to see whether the cancellation was a gift, or just the lender writing off bad debt. If it was not a gift, then the borrower may have income in the amount of the cancellation (provided they were not insolvent at the time of the cancellation). The lender probably can not take a bad debt deduction because they were related parties.
However, because this is between family members, then the cancellation is most likely, under the facts and circumstances, a gift. Under that case, the lender is making a gift of the amount cancelled (including foregone interest) to the borrower at the time of the cancellation. The borrower does not have cancellation of indebtedness and does not have to report anything, and the lender has to report the amount forgiven as a gift.
But the gift tax annual exclusion is currently $13,000 or $26,000 for a married couple. If the amount cancelled plus any other gifts from the lender to the borrower in the same calendar year is below the annual exclusion, then the lender does not have to report the gift.
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