If you can’t pay your mortgage or credit card debt, you’ve probably wondered what happens if a lender cancels or forgives your debt. It’s important to understand that if you owe a debt that is officially cancelled or forgiven, it may be taxable.
What Forgiven Debt Is Taxable?
In general, if you borrow money from a lender and they cancel all or a portion of it, you must add the cancelled amount to your income and pay tax on it. For example, let’s say you have a $25,000 credit card balance that you can’t pay because you lost your job. After several months, the card company offers to reduce your debt to $15,000 if you pay $5,000 a month for three months. If you accept that deal and pay up, they cancel the remaining $10,000 balance. But that’s not the end of the story.
Why Is Forgiven Debt Taxable?
When a lender cancels debt in excess of $600, they must report it to the IRS on Form 1099-C, Cancellation of Debt and send you a copy at the end of the tax year. Receiving this form is a nightmare for many people who didn’t know that most cancelled debt is taxable.
Here’s why you have to pay tax on most forgiven debt: When you borrow money or make a charge on a credit card, you get to use that money without paying tax on it, because the understanding is that you’re going to pay it back. But when you no longer have an obligation to pay it back (because the lender forgives the debt), you have just received income from the lender.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The good news is that there are important exceptions to the tax rule that I’m going to cover. The first one is the Mortgage Forgiveness Debt Relief Act. This legislation was created in response to the real estate meltdown and mortgage crisis, so the IRS doesn’t kick a man when he’s down! After all, if you can’t afford your house, how in the world could you turn around and pay a massive tax bill at the end of the year?
This regulation allows you to exclude any debt from taxes that’s forgiven on your main home–but not on a second home, a rental property, or a business property. Nor can you exclude forgiven debt for any other type of loan or credit card under this law.
The debt forgiveness relief applies no matter if the mortgage debt is cancelled due to a short sale (where proceeds don’t cover the mortgage balance), bankruptcy, or due to a mortgage modification. The regulation shelters up to $2 million of qualified debt from taxation (or up to $1 million if you’re married and file taxes separately). The debt must have been used to buy, build, or improve your main home and be secured by it. If your mortgage debt was refinanced, it can be a little tricky because it’s eligible for the tax exclusion, but only up to the amount of the previous mortgage principal balance.
It’s great to have debt forgiveness regulations in place that help struggling homeowners; however, the tax benefit of the Mortgage Forgiveness Debt Relief Act only extends through 2012.
Bankruptcy and Forgiven Debt
The second major exception to the rule about the taxation of forgiven debt applies to Title 11 bankruptcy proceedings. No debts that are discharged through bankruptcy are considered taxable income. Read more about how your debts are treated in bankruptcy.
Insolvency and Forgiven Debt
The third exception to taxation on forgiven debt comes into play if you’re insolvent, which means that the total amount of your debt exceeds the fair market value of your total assets. Your assets include everything you own, such as a car, furniture, life insurance policies, investments, and retirement accounts. If you can prove that you were insolvent immediately before a debt was cancelled,—such as an auto loan, student loan, or credit card—some or all of it may not be taxable.
This isn’t a complete list of debts that can escape taxation when forgiven, so be sure to refer to IRS Publication 4681 for more information. The publication contains a worksheet you can use to figure out whether you qualify for insolvency. If you have forgiven debt that’s not taxable, you still have to report it to the IRS by completing a few lines on Form 982 and attaching it to your tax return.
How to Prepare for Taxes on Forgiven Debt
If you have a forgiven debt that is taxable, it’s a good idea to meet with a tax accountant so they can review your financial situation and estimate your tax liability. You may not like what they tell you, but at least you can start planning for an unusually large tax bill. Consider creating a savings plan or adjusting your withholding at work to offset an upcoming tax liability.
In chapter 10 of my award-winning book, Money Girl’s Smart Moves to Grow Rich, you’ll find more information about taxes and get tips to choose the right tax professional for your situation.