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Tax Consequences of Forgiven Debt

TAX CONSEQUENCES OF FORGIVEN DEBT

                I am not a tax attorney nor am I an accountant and I do not hold myself out as either, but the issue of the consequences of forgiven debt is often a topic raised by my bankruptcy clients.

Debts discharged in a bankruptcy case do not result in tax consequences.  However, if you avoid filing bankruptcy because you were able to successfully negotiate a settlement with a creditor to pay a lesser amount or you lost a home to foreclosure, personal property to repossession or you defaulted on credit card debt, you may have been “forgiven” a debt.

Forgiven debt is considered to be income by the Internal Revenue Service (IRS).  The result may be you owe the IRS more taxes because of the forgiven debt.  The reason this happens is because the IRS is counting the forgiven debt as income to you!

A financial institution, bank, credit union, credit card company or government agency that forgives or writes off a debt that you owe that that is more than $600.00 of the debt’s principal is required to send you and the IRS a 1099C form in January of the coming year.  A 1099C form is an income reporting form that is to be used in reporting income on your tax return and you must pay tax on that forgiven debt “income.”

Even if you get a 1099C form from a creditor you may not have to report the forgiven debt as income, there are some exceptions.  If you lost your primary residence to foreclosure and the mortgage was to buy, build or restore the home and the “forgiveness” of the debt took place between 2007 and 2012.  There is a mortgage exception that will help you.  There are limits on the exception to balances of less than 2 million dollars.  Be sure to see a qualified Certified Public Accountant (CPA) in the preparation of your taxes when faces with forgiven debt.

There are other exceptions including student loans cancelled because you worked in a particular profession for a particular employer as required when you took the loan and your diligence resulted in the cancellation (see IRS Publication 525).  Another exception exists for forgiven debt that would have been deductible on your tax return if you paid it.  Still another exception exists if the debt was forgiven as a gift to you (this would be a rather unlikely situation).

There may in fact be some additional exceptions that a good CPA may find and in any event, the additional forgiven income is only one small component of your overall tax liability when doing your taxes.  In fact taxes on forgiven debt are not owed if you were insolvent before the debt was forgiven.  Insolvency may mean different things to the IRS than it does to you, so again, use the services of a competent CPA when preparing your tax return requires that you deal with income in the form of forgiven debt.

If you are in foreclosure or contemplating the “short sale” of a property, see a bankruptcy attorney before the foreclosure or short sale are complete.  A completed foreclosure or short sale may result in a non-dischargeable tax debt for forgiven debt that the filing of a bankruptcy case may have wholly avoided!  Most bankruptcy attorneys will charge you NOTHING for the consult – do not wait.

If you receive a 1099C form from a creditor, you will need to complete IRS Form 982 if you are claiming an exemption applies in your case.  The form can be complicated and claiming the insolvency exception may be tricky.  Remember my entreaty above – uses the services of a competent CPA to prepare your taxes if you receive a 1099C form from a creditor for forgiven debt

Bruce C. Truesdale