Tax Consequences of Debt Settlement or Canceled Debt

If you settled, cancelled or had debt forgiven, you could end up owing income taxes to the IRS or your State. The IRS considers debt that is settled for less, forgiven or cancelled as income. Why? Well if you spent $10,000 dollars on a credit card and say $7,000 was forgiven, you received essentially $7,000 of tax-free income. There are exceptions though to this rule.

Why & How Creditors Notify the IRS of Settled, Canceled or Forgiven Debt

Your creditors (e.g. banks, credit card companies, hospitals, an auto dealership) must report any amount that is forgiven of $600 dollars or more. This typically only applies to the principal amount and not forgiven interest or penalties. The process starts whereby a creditor will notify you and the IRS with a 1099-C form after they charge off or write off your debt as uncollectible. Creditors do this to individuals who default or settle for less because they want to lower their tax liabilities. The 1099-C amount must be reported as income on your Federal tax return (if it does not meet any exceptions discussed below). Make sure that the settlement or canceled debt amount on your 1099-C is correct. Moreover, understand that a creditor normally cannot write off your debt, send you a 1099, and then sell your debt as well to a collection agency. Even if they do, you should not be held liable for the debt in most cases. The IRS also stresses that you should report any amount less than $600 on your tax return.

When Debt Settled or Forgiven Is Not Considered Income

There are a few exceptions to the IRS rule that debt settled or forgiven is considered income. In other words, just because you defaulted on a debt obligation does not mean that you necessarily will have to pay taxes on the forgiven amount. Here are a few exceptions you should know about:

Mortgage Debt Forgiveness and IRS Taxes

If part or all of your mortgage is canceled, you normally would have to pay taxes on the amount forgiven if it happened before 2007. With a foreclosure, repossession, or abandonment, the forgiven amount would be equivalent to the deficiency, which is properly defined as the difference between your original mortgage amount and what the bank sold the property for (its Fair Market Value). For tax years 2007-2012, the Mortgage Forgiveness Debt Relief Act of 2007 excludes mortgage debt forgiven up to $2 million dollars (you will not have to report it as income) as long as it was your primary residence. If you are married and filing separately, then the amount you do not have to report as income is $1 million. If you refinanced or restructured your mortgage to improve your home this qualifies for the exclusion. However, if the loan you defaulted on was used for any other purpose you will need to report the canceled mortgage debt amount as income. Realize that this exception does not apply to secondary residencies, credit card debt, or car loans.

You Do Not Have To Report Forgiven Debt Up to the Point of Insolvency

If you were insolvent before your debt was forgiven, typically you will not be held responsible for taxes. Insolvency means that your debts outweigh your assets. However, debt will only be forgiven up until the point of insolvency. For example, if you owed $25,000 on a credit card (assuming your only debt), and you had $10,000 in assets before the debt was forgiven, you were insolvent by $15,000. Therefore, if your credit card company settles with you for $5,000, you essentially saved $20,000. Therefore, you will only have to put $5,000 of the $20,000 forgiven on your tax return. To claim insolvency, use Form 982 and provide a financial statement of assets and liabilities (use the one in IRS Publication 4681) with your tax return.

Forgiven Debt Due to Identity Theft

If you accumulated debt that you were not personally liable for because your identity was stolen, you will not have to pay taxes on any forgiven amount. In fact, if a creditor sends you a 1099-C make sure you call them to correct the situation.

Certain Student Loan Debt Does Not Have To Be Reported

Sometimes certain student loans can be canceled if you work in a profession for an amount of time for "broad class of employers." You would not have to report a canceled student loan as income if you agreed to this before the loan was given. The loan must have been given by Government, a tax-exempt public benefit corporation that has assumed control of a Government hospital whose employees are considered public employees," or an educational institution under agreement with the former two that provided funds so it could make the loan. Even an educational institution under the direction of a 501(c)(3) or governmental entity that encourages professions in areas with "unmet needs" qualifies. The IRS code is complex here so it is best to reach out to a tax professional if you have questions.

Debt Canceled With a Chapter 11 Bankruptcy

Qualified Farm Debt That Is Canceled by a Qualified Person

Real Property Business Debt That is Canceled

Other Important Notes Regarding Taxes and Debt Settlement

I know these facts can be tough to swallow if you have you lost a piece of property or you are up to your neck in debt. Realize the creditor has up to 3 years from the last "collection activity" to issue you a 1099-C. A creditor who has forgiven debt will issue you a 1099-C regardless of whether you have to report it as income or not. When you receive a 1099-C, report the amount in box 2, unless the interest is deductible. If the interest is deductible, report the net amount (box 2 - box 3).

If you need any help al all regarding forgiven debt you didn't realize you had to pay taxes on, contact us today for a free consultation and quote in order to resolve your IRS or State tax problems.

Select... $7,500 to $9,999 $10,000 to $14,999 $15,000 to $19,999 $20,000 to $24,999 $25,000 to $29,999 $30,000 to $39,999 $40,000 to $59,999 $60,000 to $79,999 $80,000 to $99,999 $100,000 + Select a state Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware District of Columbia Florida Georgia Hawaii Iowa Idaho Illinois Indiana Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Missouri Mississippi Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming

Tax Settlement
Find out different types of tax settlements, how a tax settlement works and how you can settle taxes owed with the IRS.

Partial Payment Installment Agreement
This settlement will allow you to pay back IRS taxes in monthly amounts that are less than the total amount owed, that is if you don't qualify for the regular installment agreement

Penalty Abatement
Remove all of or part of your penalties owed by the IRS by proving to them you had a legitimate reason for not filing or paying your taxes on time.

IRS Payment Plans
When you are unable to pay your taxes in full the IRS offers several options for taxpayers to pay back their tax liabilities.

Tax Settlement Help
Do you need help settling taxes? Our Tax Team (Tax Attorneys, Tax Lawyers, CPA's, IRS Agents) can find the best tax settlement method for your situation. Find out how our tax settlement service works.