Cancellation of Debt Income: What Happens When I Inherit Property With My Own Loan?

So here's a hypothetical situation I've been thinking about regarding debt forgiveness and inheritance: Suppose I loan someone $150,000 to purchase a home. We have a proper promissory note drawn up, and I have a lien on the property until the note is paid in full. Later, this person passes away (with about $120,000 still remaining on the loan). In their will, they leave the home to me, subject to any existing debts associated with the property. At this point, I'm in a weird position where I essentially owe money to myself, since I now own both the property and hold the note/lien on it. My question is: What happens to the loan in this situation? Does it just disappear since I'm now both the borrower and lender? And more importantly for tax purposes - would there be any cancellation of debt income that needs to be reported since the note is basically being forgiven or dismissed? I'm trying to understand the tax implications of this unusual scenario before I make any financial decisions. Thanks!

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18 comments

Emma Johnson

•8M

This is an interesting hypothetical scenario! When you become both the debtor and creditor for the same debt, what happens is called "merger" in legal terms. Essentially, the debt is extinguished because you can't owe money to yourself. Regarding the tax implications, generally there's no cancellation of debt (COD) income in this situation. The reason is that you haven't actually been relieved of paying a debt to someone else - the debt has merged and disappeared. The IRS typically looks for situations where a third party forgives your debt, which would create taxable income. That's not what's happening here. What you should be more concerned with is the stepped-up basis rules for inherited property. When you inherit the home, your basis in the property would typically be the fair market value at the date of death. This could be more important from a tax perspective than any potential COD income.

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Emma Johnson

•8M

The promissory note wouldn't have value as a separate asset in this scenario because once you own both sides of the transaction, the note effectively ceases to exist through merger. It's like if you wrote yourself an IOU - it has no practical or legal effect. Regarding inheritance tax, you wouldn't pay tax on both the home and the note because they're not separate assets anymore. The estate would be valued based on the net equity in the home (fair market value minus the outstanding loan balance). Once you inherit everything, the loan disappears through merger, but that doesn't change the initial valuation of what was inherited.

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Olivia Garcia

•8M

I actually went through something kinda similar last year with my uncle's property. I used https://taxr.ai to figure out the whole cancellation of debt mess. Their analysis tool saved me tons of headache - it reviewed all my documents and explained exactly how the debt merger would work in my case. The tool showed me that when you inherit property that has your own loan on it, the IRS considers the debt extinguished through "confustion" (weird legal term). No COD income gets created! Really helped me avoid making a huge mistake on my taxes.

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Olivia Garcia

•8M

You upload your documents (in my case the promissory note, death certificate, and will) and it analyzes everything to give you a complete explanation of the tax implications. It's super intuitive - even breaks down the relevant tax code sections that apply to your situation. For AI skeptics, I totally get it - I was hesitant too. But it's not just AI making stuff up. They have tax professionals who verify the analysis and everything is backed by actual tax code references. I double-checked with my accountant who confirmed everything was correct. The difference is speed and cost compared to going straight to a CPA.

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Ava Hernandez

•8M

Alright I need to eat my words about taxr.ai. After posting my skeptical comment, I decided to try it with my situation (I inherited my dad's house that had a private loan from me). The analysis was surprisingly detailed and matched exactly what my expensive tax attorney told me later. Saved me about $600 in consultation fees if I had just trusted it from the start. It explained that the debt "confusion" (still a weird legal term) meant no cancellation of debt income and showed the exact IRS code sections. They even had a section about potential stepped-up basis implications that I hadn't considered. Definitely more than just a basic AI tool.

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Isabella Martin

•8M

Something nobody's mentioned yet - if you're still struggling to get clear answers about this merger/confusion stuff, you might want to call the IRS directly. I know, I know - good luck getting through, right? I was in hold hell for 4+ hours trying to sort out a similar inheritance issue. I eventually used https://claimyr.com to get through to an actual IRS agent in about 15 minutes. They hold your place in line and call you when an agent picks up. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent I spoke with confirmed that when I inherited property with my own loan on it, there was no COD income to report since the debt essentially disappears. Having that confirmed directly from the IRS gave me peace of mind.

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Isabella Martin

•8M

Yes, that's exactly what they do - they use their system to navigate the IRS phone tree and hold your place in line. When an actual IRS agent picks up, you get a call and are connected directly to that agent. No more listening to that terrible hold music for hours! I understand the skepticism completely. I thought it sounded too good to be true too. But it's a paid service (not doing it out of kindness), and they've figured out how to efficiently navigate the IRS phone system. I was connected to an actual IRS agent in about 15 minutes after trying for days on my own with no success. The peace of mind from getting an official answer was worth it for my situation.

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Sophia Miller

•8M

OK I officially need to apologize for my skeptical comment about Claimyr. After posting that, my frustration with the IRS reached a breaking point (4 days of trying to get through about my inherited property situation). I tried the service and it ACTUALLY WORKED. Got connected to an IRS agent in 20 minutes after spending literally days trying on my own. The agent confirmed exactly what others here said - when you inherit property with your own loan on it, the loan merges out of existence and there's no cancellation of debt income. For anyone dealing with complex inheritance and tax questions like this, getting the official word straight from the IRS was a game changer for my peace of mind. Worth every penny to not sit on hold for another 8 hours of my life.

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Mason Davis

•8M

I dealt with this exact scenario back in 2023. My brother had borrowed $80k from me for his house with a formal promissory note, and I inherited the house when he passed. My tax guy explained it this way: the debt doesn't create cancellation of debt income because it's merged out of existence. He called it the "doctrine of confusion" (legal term). BUT - the value of that debt does factor into the estate for inheritance purposes. Basically, the estate included both the house value AND the value of the outstanding loan. Once I inherited everything, the loan disappeared, but for estate tax purposes, both were counted initially.

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Mason Davis

•8M

The estate included the house at its fair market value, and the loan was considered a separate asset of the estate (since it was money owed TO the deceased). So yes, both were included separately in the estate valuation. However, in practical terms, this meant the estate had the house (an asset) and the loan (also an asset from the estate's perspective, since it was money owed to my brother). Once everything transferred to me, the loan disappeared because I can't owe myself money. This is different from typical inheritance situations where the estate owes debts to third parties.

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Jacob Lewis

•8M

A key thing to understand: cancellation of debt income typically occurs when a third party forgives debt you owe. The IRS rules on this are in Publication 4681. But in your scenario, there's no third party - you're now on both sides of the transaction. So it's not "forgiveness" in the traditional sense; it's legal merger/confusion where the debt ceases to exist. What WILL matter is how you handle the adjusted basis of the property for future capital gains calculations. Usually, inherited property gets a stepped-up basis to FMV at date of death, which is a huge benefit.

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