Canceled Debt and Taxes – What You Need to Know

Canceled Debt and Taxes – What You Need to Know

Canceled or forgiven debt can be a huge boon to consumers. After all, everyone likes the idea of being released from their obligation to pay. However, one thing that people don’t often consider is that canceled and forgiven debt can count as taxable income. The IRS requires you to report any canceled debt and add it to your gross income. This can cost consumers hundreds or thousands of dollars in taxes, as they can find themselves jumping up a tax bracket.

Moreover, unlike wages which have taxes taken out of them, the canceled debt is raw income. Therefore, unless you’ve been putting money aside to cover the taxes on your canceled debt, you could find yourself facing a huge and unexpected bill. To make matters worse, the IRS will not cancel tax debt, so your canceled debt could wind up costing you.

There is some good news though, not all canceled debt is taxable. This guide will help you understand what kinds of debt are and aren’t considered taxable income. You should use this information to understand what your obligations will be if you’re looking into a debt cancelation or forgiveness program.

When Do You Pay Taxes on Canceled Debt?

Most canceled debt is considered taxable income. The best way to tell if your canceled debt will be taxed as income is to ask your lender or creditor if they will be sending you a form 1099-C if they cancel your debt. Form 1099-C is a communication between you, your lender, and the IRS. It tells the IRS that your lender canceled your debts, and that they understand the canceled debts to be taxable income.

Companies need to send these forms because of the way that their taxes work. A company or individual who cancels debt can usually write off some or all of the canceled debt on their taxes. However, in order to get this tax break, they need to send out the appropriate forms. Therefore, the company or lender will certainly send you a 1099-C so they can claim your canceled debt as a write-off.

Generally, the best approach is to assume that any canceled debt will be counted as taxable income. This approach helps keep you safe and ensures that you won’t be facing credit or legal issues from an unexpectedly large tax bill. However, there are some situations where canceled debt isn’t taxable income.

What Kinds of Debt Cancelation Aren’t Taxed?

Most debt cancelations that aren’t canceled income are the result of some kind of financial trouble. The government recognizes that taxing debts that are canceled because you don’t have an ability to pay puts consumers in an incredibly tight spot. Moreover, it understands that these consumers are not likely to be able to afford the increased tax bill. As a result, collecting on these taxes would create tremendous human hardship and a host of challenges and hassles for the government. Therefore, you should pay close attention to this list of types of debt cancelation that are exempt from taxation.

Bankruptcy Debt

One of the most common reasons debts are forgiven or discharged is through the process of bankruptcy. Any debt discharged through bankruptcy is not considered to be taxable income. Bankruptcy is a legally protected process to help people who can’t afford their debts. The judicial and legal oversight of this process gives the government confidence that anyone who goes through the process won’t be able to afford an increased tax bill. Moreover, bankruptcy is intended to protect consumers and individuals, so taxing debts discharged in bankruptcy runs counter to the point of having a bankruptcy process.

Mortgage Debt from Foreclosures

The government also does not tax mortgage debt that is forgiven because the home was foreclosed upon. This is a vital exception to canceled debt as taxable income. Home owners gain many tax deductions for owning a home and having a mortgage, so the combination of losing those deductions and suddenly facing a massive tax bill would be devastating for citizens.

Insolvency

Insolvency is one of the biggest exceptions to canceled debt as taxable income. Insolvency is the IRS’s way of saying “broke”. Most canceled debts occur because of a consumer’s inability to pay. After all, lenders and creditors don’t make money by forgiving debts. Therefore, most people won’t have debt canceled unless they are insolvent.

This category of exemption can apply to debt settlement. For example, if a consumer owes $50,000 in credit card bills, but settles them for $5,000 because they will not ever be able to pay off the balance, then the $45,000 in canceled credit card debt will be exempt from taxation.

Student Loans Debt Cancelation Programs

Another common type of debt cancelation comes in the form of student loan forgiveness programs. These programs offer to forgive student loans in exchange for different types of service. The most common programs ask graduates to teach at under-privileged schools. However, not every program which forgives student loan debt does so in a way that’s non-taxable. Make sure you check with the specifics of any program you’re considering so you know what to expect.

Forgiven Deductible Interest

Sometimes lenders won’t forgive an entire debt and will just forgive the interest on that debt. This allows them to lower your bills and get the money they invested back without taking a total loss. If the interest on the forgiven debt is tax deductible, then this type of debt forgiveness does not count as taxable income.

Debt Cancelled as a Gift

Finally, debt which is cancelled as a gift is not tax deductible. These types of debt cancelations usually occur between friends and families. The IRS is unlikely to think that canceled debt from banks or other institutions where you have a provider-client relationship is a gift. Additionally, if the gift totals more than $13,000, then the person canceling the debt needs to report it on their tax return.

 

As you can see, understanding the ways that canceled debt relate to taxes can be a complex tax. If you have any questions or are considered ways to get your debt canceled, talk to a certified tax specialist or accountant to understand what the tax implications might be.