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The Tax Consequences of Debt Forgiveness

August 11, 2014

Alex Moretsky

Settling a debt for less than the full amount owed seems like a blessing when you are burdened with lots of it. Unfortunately, the Internal Revenue Service and Pennsylvania Department of Revenue takes a different view of your good fortune.

When a creditor writes off or reduces a debt, it usually reports the amount written off as lost income to reduce its own tax burden. The IRS treats the forgiven amount as gained income for you and wants to collect a tax on this phantom income. For example, if you owe VISA $15,000.00 and the company decides to reduce your debt to $5,000.00, the difference of $10,000.00 is considered income and, consequently, taxable.

Any financial institution that forgives or writes off a debt of $600.00 or more will send a 1099-C to the IRS. It is incumbent upon the debtor to list the income on his tax return to avoid any discrepancies between him and the creditor.

The rule even applies after your property has been foreclosed or repossessed, provided the lender forgives the difference between what you originally owed and what the property sold for, otherwise known as a “deficiency”. This problem became especially acute during the Great Recession. In view of the toll the recession was taking, Congress passed the Mortgage Forgiveness Debt Relief Act. The Act forbids the IRS to tax the deficiency on homes foreclosed between the years 2007-2014. But it applies only to one’s primary residence. Vacation and investment properties are not eligible for debt forgiveness and monetary limits apply.

Aside from the Mortgage Forgiveness Debt Relief Act, here is a list of exceptions to reporting income on a tax return when a financial institution issues a 1099-C:

  1. A student loan might be cancelled because you worked in a specific profession or for a class of employers for a period of time.
  2. The cancelled loan would have been deductible if you had paid it.
  3. The cancellation or write-off is a gift.
  4. You discharged debt in bankruptcy.
  5. You were insolvent before the creditor agreed to settle or write-off the loan.

If you are insolvent, meaning your debts exceed the value of all your assets, you can exclude cancelled debt from income up to the amount you are insolvent.

  • Assets …….$ 80,000
  • Less:Debt ..$100,000
  • Insolvent… $ 20,000
  • Debt Cancelled……..$30,000
  • Less:Insolvent……….$20,000
  • Include as Income…$10,000

You might wonder whether it is worth trying to negotiate a decrease in the amount owed on a debt. In some cases, it might not be worth it. In other cases, however, the result is more than worth it. Speak to a Montgomery County, Pennsylvania tax and bankruptcy attorney to discuss your specific situation.