Will I Owe Taxes on My Discharged Debts?

November 21, 2011

One of Ben Franklin’s most famous quotes goes, “”‘In this world nothing can be said to be certain, except death and taxes.”

U.S. taxpayers are taxed for so many transactions. One of the lesser-known taxes is the “cancellation of debt” tax. Many consumers who successfully resolve their debts for “pennies on the dollar” receive a nasty surprise at the end of the tax year. They are issued an IRS 1099-C: a “cancellation of debt” form. The U.S. Internal Revenue Service considers forgiven or canceled debt as income. Any creditor or debt collector who agrees to accept at least $600 less than the original balance is required to file a 1099-C form with the IRS and to send debtors a canceled debt notice. Taxpayers must report the forgiven or canceled debt as “income” on their federal income tax returns.

Fortunately, there are six exceptions to the rule that you must pay tax on forgiven or canceled debt:

Exception 1: If the debt is a foreclosure that qualifies under the Mortgage Forgiveness Debt Relief Act. Under this Act a debt that is reported as canceled after a foreclosure may be excluded from income.

Exception 2: Debts canceled while the taxpayer is insolvent. Insolvent means broke. This exclusion applies to an amount beyond your total assets. For instance, if you have a canceled debt of $20,000, and you have $5,000 in assets, you must report the first $5,000 of the canceled debt as income.

Exception 3: Student loans forgiven under a federal program. Some federal programs will forgive a portion or all of a person’s student loan debt after you worked a period of time. This forgiven debt is not taxed.

Exception 4: Any forgiven interest that would have been deductible as a business debt (that does not include personal credit card interest).

Exception 5: If the canceled debt is a gift, it is not taxable. This exception generally only applies when the debt is between family or friends.

Exception 6: If the debt was discharged in bankruptcy, it is not taxed as income.

Some bankruptcy debtors receive 1099-C forms in the mail. Simply tell the IRS that you have discharged the debt in bankruptcy and owe nothing. File IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your income tax form.

Most bankruptcy debtors do not receive 1099-C forms. If you receive one, speak with your bankruptcy attorney to confirm that the debt was discharged. Your bankruptcy attorney can assist you in resolving the debt and avoiding problems with the IRS.

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