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What You Need to Know About Forgiven Debt and Taxes

Find out when you have to pay tax on canceled debt and when you don’t.

By
Laura Adams, MBA
October 11, 2010
Episode #193

If you’ve had a tough time paying a debt, like a mortgage or a credit card, you may have wondered what would happen if all or a portion of it was “settled” or forgiven. If a creditor lowers or completely cancels a debt that you owe, does that amount of money just vanish into thin air? In this article we’ll cover what happens if a debt is forgiven and when you have to pay tax on it. 

The podcast edition of this article was sponsored by Go To Meeting. Use Go To Meeting to hold your meetings over the Internet and to give presentations, product demos, and training sessions right from your PC. For a free, 45-day trial, visit GoToMeeting.com click the try it free button and enter the code “podcast.”

What is a Forgiven or Canceled Debt?

Here’s an example of a canceled debt: Let’s say you have a $15,000 credit card balance and stop making payments because you lose your job. You call the card company and negotiate with them to reduce your total debt to $9,000 on the condition that you pay $4,500 this month and $4,500 next month. If they settle with you by accepting a total of $9,000 on a $15,000 debt, they cancel the difference, or $6,000. But that’s not the end of the story, because the amount that got canceled gets added to your taxable income.

If your average tax rate is 25%, you’ll have to shell out $1,500 (25% of $6,000) on that amount of forgiven debt. So though you originally were “saving” $6,000, you’re really only saving $4,500 (after taxes)—which is still significant, but can be a really rude awakening at tax time. At the end of this article I’ll give you some quick and dirty tips to help you prepare for a big tax bill, so you aren’t caught by surprise.

Do You Have to Pay Tax on All Canceled Debts?

There are some situations, however, when a canceled debt is not taxable, including:

  • Bankruptcy: is a legal action that helps individuals and businesses get a fresh start when they can no longer pay their creditors. Debts discharged through bankruptcy are not considered taxable income.

  • Insolvency: is when the total of all your debts is more than the fair market value of all your assets, prior to the debt cancelation.

  • Qualified student loan: is a loan that includes certain obligations such as working in a certain profession or in an underserved geographic area for a period of time in exchange for tax-free loan cancelation.

  • Qualified mortgage: is a debt secured by your main home that’s used to buy, build, or substantially improve the property.

(This isn’t a complete list of non-taxable forgiven debt, so be sure to refer to IRS Publication 4681 for more information.)

What Is the Mortgage Forgiveness Debt Relief Act of 2007?

Debt that’s canceled due to bankruptcy, insolvency, a qualified student loan, or a mortgage on your main home is not taxable.

Canceled mortgage debt is also excluded from tax due to legislation passed in 2007 and 2008. The Mortgage Forgiveness Debt Relief Act applies to mortgage debt that’s forgiven from 2007 through 2012 only and it provides welcome tax relief to struggling homeowners. You can generally exclude up to two million dollars of debt that’s canceled due to a mortgage modification or even due to a foreclosure.

As I mentioned, the debt must have been used to buy, build, or to substantially remodel your main home. Refinanced debt qualifies too, as long as the money wasn’t used for other purposes, like to pay off a credit card, buy a car, or to take a vacation. Debt that’s forgiven on credit cards, vehicles, or second homes, does not qualify for this particular tax exclusion. However, it’s possible that other tax relief provisions that I previously mentioned—like bankruptcy or insolvency—may apply to your situation. If you’re not sure whether you qualify for insolvency, use the worksheet in IRS Publication 4681 to find out.

How to Report Canceled Debt on Your Tax Return?

If you have a canceled debt that’s not taxable, you still have to report it by completing a few lines on Form 982 and attaching it to your tax return. To keep up with canceled debts, creditors have to report those in the amount of $600 or more on Form 1099-C, Cancellation of Debt. If your home was foreclosed or repossessed, you might receive Form 1099-A, Acquisition or Abandonment of Secured Property from your lender instead. Both you and the government should receive a copy of these forms by February following the tax year that the debt was canceled. 

What You Need to Know About Forgiven Debt and Taxes

Now, let’s talk about taxable canceled debt. If you get a creditor or a debt collector to cancel all or a portion of a debt that’s taxable—like a credit card or a medical debt—remember that the taxman won’t let you off the hook so easy. If you don’t want to risk getting an IRS audit and the resulting fines and penalties, any 1099 form that you receive must be filed with your tax return.

To finish up, here are four tips to help you prepare for a larger-than-normal tax bill that you could face due to a forgiven debt:

  1. Seek advice from a tax professional. Have an experienced tax preparer or an accountant look at your entire situation and estimate your tax liability, so you’ll know what to expect and can plan for it.

  2. Put your savings on autopilot. If you get paid by direct deposit, have a portion of each paycheck sent to a separate savings account. Don’t touch that money except to pay your upcoming tax bill.

  3. Adjust your withholding at work. You may want to have more federal income tax withheld from your paycheck to offset your upcoming tax liability. Use the IRS Withholding Calculator at irs.gov to find out if you should submit an updated Form W-4 to your employer.

  4. Double check your 1099. Creditors can pile on additional interest and administrative fees to your canceled debt. Make sure that you agree with the amount reported on a 1099 before your taxes are due. 

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More Resources:
IRS Brochure: Tax Relief for Struggling Homeowners
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness
Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonment
Publication 525, Taxable and Nontaxable Income
Publication 544, Sales and Other Dispositions of Assets
Publication 523, Selling Your Home

Image courtesy of Shutterstock

 

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