If some of my debt is forgiven, will there be tax consequences?
What if you could reduce your mortgage balance by $100,000? What if your credit card debt simply disappeared? While you probably won’t see results quite so dramatic, it is possible to have your debts partly forgiven by your lenders through short sales, settlements, and other processes. Before you pick up the phone, however, you might want to consider the tax consequences of forgiven debt.
As a general rule, the IRS, and state taxing authorities, imputes the amount of debt that’s been forgiven to you as income. This means that your income tax bill goes up by the amount of the debt that’s been forgiven.
See also: Can bankruptcy stop NJ tax garnishment?
If you’re behind on your credit card payments or payments for medical debt, you may be able to reach an agreement with your lender to pay less than the full balance you owe. It’s called debt settlement and lenders are willing to do it because they can get at least partial payment in a lump sum and avoid the time and expense of pursuing you through the legal system.
Say you had $10,000 in credit card debt and you couldn’t make the payments. If you’re paying less than the full balance every month, you’re also racking up massive amounts of interest and may never be able to catch up. You call your credit card company and offer to pay then $5,000 today in return for forgiveness of the entire debt – they accept. Now you’re out $5,000, but you’re debt free. This probably sounds like a great deal. Of course, it’s not that simple.
You owed $10,000 and only paid $5,000. As far as the IRS is concerned, you’ve just earned $5,000. The logic is that you no longer have to pay the $5,000 that was forgiven, so you’re $5,000 ahead of where you would otherwise have been. That makes it income for tax purposes. Your lender will send you (and the IRS) a 1099-C form detailing the amount of the forgiven debt and you’ll have to declare it on your tax returns. So, before you decide on a settlement, take a look at your tax bracket. How much will you have to pay in taxes for that extra income? Will the amount of forgiven debt push you over into the next higher tax bracket? Consider also that a settlement will negatively impact your credit report.
If you’ve fallen behind on your car payments, your lender might repossess the vehicle. Then you have a short amount of time to cure your default by paying off what you owe or the lender will sell the car. If your car sells for less than you owe and the lender pursues you for the rest, which is called the “deficiency,” then you don’t have to worry about it for tax purposes. If the lender forgives the amount of the deficiency, it’s considered income and you’ll get a 1099-C.
With one important exception, forgiven student loans are considered income. Some loans include a clause allowing for partial or full forgiveness of the debt if the student works in a particular industry for a particular amount of time after graduation. If you fulfill that requirement and your loan is forgiven, it’s not considered income. The loan must be from the government or a government-funded school program aimed at benefitting underserved occupations and areas. The work you do is considered repayment, so for tax purposes you’re repaying the loan rather than having it forgiven.
If you’re behind on your mortgage payments, your lender may decide to foreclose on your home. You and your lender may also decide to “short sell” your home, or sell it for less than you owe. In either case, the bank may decide to pursue you for the “deficiency,” or the remainder of your debt. That doesn’t impact your tax liability, but they can sue you and attempt to garnish your wages or levy your bank accounts. The bank may also agree to forgive the deficiency. I’m sure you can guess by now that that amount is generally considered income. In the wake of the 2008 crisis, however, there is a major exception.
The Mortgage Forgiveness Debt Relief Act of 2007 allows you to escape up to $1 million (or $2 million for a married couple filing jointly) in tax liability for a debt incurred to buy, build, or improve your primary residence. It also applies to debt from refinancing any of those activities. The Debt Relief Act only covers debts forgiven from 2007 to 2013 and only applies to primary residences; the amount of debt forgiven outside of that time range or for other property is still taxable as income.
Mitigating Your Tax Burden
There are two ways to avoid paying taxes on debts you don’t have to repay fully. First, if you’re insolvent, you won’t incur tax liability for any forgiven debt of any kind. To be insolvent, your total debts (including the one that’s going to be forgiven) must be greater than your total assets.
Debts Discharged in Bankruptcy are Not Taxable
If you’re not insolvent, the only way to avoid the tax liability is to file for bankruptcy. Debts forgiven through bankruptcy discharge are not considered income. However, the decision to file for bankruptcy is a serious one and affects all of your finances, not just one specific debt.
The best option for you will depend on your personal circumstances. To determine what impact debt forgiveness will have on you and your tax liability, talk to an experienced attorney or accountant.