Thrifty Spending Issue 96: Feature Article

FEATURE ARTICLE:  Debt Forgiveness: Is it truly forgiven or is it transferred to one’s income tax?

Ever settle on a debt and wonder what will happen to the amount that wasn’t paid?

For example, if a credit card debt totaling $30,000 was settled for $7,000, what happens to the remaining $23,000? Is it just forgiven or is it taxable?

Forgiven debt: how it works

In general, if one owes money and it’s eventually written off, as far as Uncle Sam is concerned, the destroyed debt is taxed like income. Using the credit card debt example, since the debt for $23,000 is no longer owed, a 1099-C  will be issued at the end of the year for this amount.

This might not seem fair. After all, it’s not like one received a check for $23,000. The forgiven debt is more like a gift, and gifts aren’t taxable. So why would the IRS treat this forgiven debt as income?

The logic lies in the way income and losses are treated for tax purposes. Basically, it’s yin and yang: One man’s deduction is the other man’s income.

When it comes to business, most transactions involving money are deductible to the one paying it and income to the one receiving it.

For example, if a bank pays interest on a savings account, they get to deduct that money as an expense on their taxes – the account holder, counts it as income. And if the bank lends money to an account holder and that money is not paid back, the bank deducts the bad debt as an expense – and the account holder includes it as income.

In short, the term “debt forgiveness” makes it seem like a gift, but it’s more like “debt deduction.” When one party is writing something off, the opposing party is typically reporting it as income.

That’s the rule and the logic behind debt forgiveness. But as with many rules, especially those relating to income taxes, there are many exceptions.

Exception: insolvency

According to IRS publication 4681, if one is “insolvent,” meaning one owes more than one owns, forgiven debt isn’t counted as income. “Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV (Fair Market Value) of all of your assets immediately before the cancellation.”

To qualify for this exclusion, you file Form 982. This is generally the form consumers file when they enter into debt settlement agreements and will probably be his best chance at avoiding paying taxes on the forgiven debt.

Exception: bankruptcy

Debt cancelled through a Chapter 7 or Chapter 13 bankruptcy typically isn’t taxable.

Exception: mortgage debt

A foreclosure often includes cancelled mortgage debt – the amount of the mortgage not recouped when the home is taken back and resold.

Since that results in forgiven debt, the result for many hapless homeowners is losing their home, then months later getting a tax form in the mail informing them they owe taxes on potentially hundreds of thousands of dollars of income they never received.

Depending on state laws, the same could be true for those doing a short-sale (selling their home for less than the mortgage balance) or participating in a program offered by a bank, such as Bank of America has offered in the past.

Fortunately Congress rode to the rescue years ago and passed a law called the Mortgage Forgiveness Debt Relief Act of 2007. This law applies to homeowners whose mortgage debt is “partly or entirely forgiven during tax years 2007 through 2012.”

To read the details, check Publication 4681. But in general, if the forgiven mortgage debt was less than $2 million for married couples ($1 million for singles), was secured by a principal residence (as opposed to a rental property or vacation home), and was used to purchase or improve the home (as opposed to buying a car or paying off credit cards), it’s not reportable as income.

Bottom line: seek assistance

These are some common exceptions that could help individuals avoid taxes on forgiven debt. There are also different rules for businesses, as well as for debts that are recourse (those for which one is personally liable) and non-recourse. State laws can also play a part, and so can other laws. For example, after hurricane Katrina, Congress passed a law allowing those in affected areas to exclude forgiven non-business debts from their income that year.

Always weigh all the options on the table before committing to a settlement. Understand the consequences thoroughly and speak to a professional when something is not clear.

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