Bankruptcy Article

Tax Consequences When a Creditor Writes Off or Settles a Debt

The IRS may count a debt written off or settled by your creditor as taxable income to you.

If you settle a debt with a creditor for less than the full amount, or a creditor writes off a debt you owe, you may owe money to the IRS. The IRS treats the forgiven debt as income, on which you may owe income taxes.

Why the IRS Can Assess Taxes on Forgiven Debts

Here's how it works. Creditors often write off debts after a set period of time -- for example, one, two, or three years after you default. The creditor stops its collection efforts, declares the debt uncollectible, and reports it to the IRS as lost income to reduce its tax burden. The same is true when you negotiate a debt reduction. The creditor will report the amount you didn't pay as lost income to the IRS.

Of course, the IRS still wants to collect tax on this money, and it will turn to you for payment. Because you no longer have to pay the full amount of the debt, the IRS treats the forgiven amount as gained income, for which you should pay income taxes.

Foreclosures and property repossessions. This rule applies even to debts you owe after a house foreclosure or property repossession. In this situation, the law can seem especially cruel: Not only have you lost your property, but you'll also have to pay income tax on the difference between what you originally owed the lender and what it was able to sell your property for (called the "deficiency").

However, the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changed this for certain loans during the 2007, 2008, and 2009 tax years only. The law provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in).  Here are the rules: 

• Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means you don’t have to pay tax on the deficiency.
• Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), you’ll owe tax on any deficiency.
• Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.  

If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove you were legally insolvent, you won’t be liable for paying tax on the deficiency. See "Exceptions on Reporting Income," below, for details on the insolvency exception.

IRS Reporting

Any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable to interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for reporting income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income.

Even if you don't get a Form 1099-C from a creditor, the creditor may very well have submitted one to the IRS. If you haven't listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or, worse, an audit notice. This could end up costing you more (in IRS interest and penalties) in the long run.

Exceptions to Reporting Income

There are several reporting exceptions stated in the Internal Revenue Code. For example, if the financial institution issues a Form 1099-C, you do not have to report the income on your tax return if:

• the cancellation or write off of the debt is intended as a gift (this would be unusual)
• you discharge the debt in Chapter 11 bankruptcy, or
• you were insolvent before the creditor agreed to settle or write off the debt.

Insolvency means that your debts exceed the value of your assets. To figure out whether or not you were insolvent, you will have to total up your assets and your debts, including the debt that was settled or written off.

Example 1: Your assets are worth $35,000 and your debts total $45,000, so you are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.

Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don't have to report $10,000 of the income, but you will have to report $4,000 on your tax return.

If you conclude that your debts exceed the value of your assets, include IRS Form 982 with your tax return. You can download the form off the IRS's website atwww.irs.gov.

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