Debt forgiveness, which is the cancellation of a debt that you owe to someone, often can lead the IRS to see an increase in your income tax bill. However, there is no simple rule to be applied to every situation. For example, if you are in bankruptcy, the IRS is unlikely to see income that can be taxed after debt forgiveness. On the other hand, when a commercial lender cancels your obligation to repay a debt, you may find yourself with income equal to the amount of debt forgiven. In this situation, you do not have any money in hand, but you can expect a tax bill on the amount of money that the lender decided could not be collected from you. Your former lender usually should send you an IRS Form 1099-C (“Cancellation of Debt”) to let you know that the debt that you no longer owe triggered an increase in income taxes at the time of debt forgiveness. Remember that the IRS also gets a copy of the 1099-C and is unlikely to forget the incomes taxes that you now owe.
You may wonder why you receive debt forgiveness income when you cannot repay a loan. One point that will be discussed later is that the IRS does not see income when a debt is cancelled so the explanation here is general. The idea behind debt forgiveness resulting in income begins with the fact that the funds you originally borrowed were not income since those funds represented money loaned to you that had to repay to the lender. When a debt is forgiven, you no longer have to have any obligation to pay back whatever amount of the loan remains unpaid – essentially, your wealth has increased now that you have money that you can keep.
As long as none of the exclusions or exceptions (which will be mentioned below) regarding debt forgiveness income applies, the formula for calculating income simply involves subtracting the fair market value of the property from the debt owed at the time that the lender took a specific action, such as foreclosure or repossession. Also, you may receive a capital gain due to foreclosure, for example; this is not debt forgiveness income but usually occurs when the property’s fair market value is greater than its adjusted basis (approximately your original purchase price plus the costs from major improvements). An amount could be excluded due to the length of time that this was your personal residence during the last five years – I won’t go into the details here because the focus is on debt forgiveness for the moment.
There are several exceptions when debt forgiveness does not lead to taxable income. The examples provide general rules about various exceptions, which could be subject to exceptions themselves – consulting with someone who handles these matters about your specific situation always is advisable.
In general, a debt that is cancelled through a gift, a bequest or devise, or an inheritance is not considered income. Certain student loans also provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. If your student loan is canceled as the result of this type of provision, the cancellation of this debt isn’t included in your gross income. To qualify for this treatment, the loan must have been made by entities in one of three categories: 1) the federal government, a state or local government, or an instrumentality, agency, or subdivision of one of those governments; 2) a tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, having employees defined as public employees under state law; or 3) an educational institution (an organization that has a regular faculty and curriculum as well as regularly enrolled students who attended educational activities at that place). Other criteria have to be met for these loans not to be income if they are cancelled. One major reason for debt forgiveness here is to encourage students to serve in occupations or areas with unmet needs in which the services provided are for, or under the direction of, a governmental unit or a tax-exempt Section 501(c)(3) organization.
There also is an exception for deductible debts. Most individuals use the cash method of accounting so income is seen when the money is received while expenses are counted when money is paid for goods or services. Therefore, when a debt was supposed to be paid but the obligation to do so was forgiven, you would not realize income at that time if payment of the debt would have been a deductible expense for you.
The Home Affordable Modification Program (HAMP) also has some exceptions to debt forgiveness income. Reduction of your principal mortgage balance generally is not income when Pay-for-Performance Success Payments and PRA investor incentive payments are involved. Meanwhile, when the principal balance is reduced due to Principal Reduction Alternative under the same program, you should expect that you have taxable debt forgiveness income. Any exception to possible debt forgiveness income can become complicated; again, seeking a professional’s assistance is the best way to protect yourself from making costly mistakes in this area.
After any possible exceptions are reviewed, you then look at the exclusions. For individuals, some of the most common situations that are excluded from consideration as income from the cancellation of a debt would be the following. The most common one probably involves bankruptcy – if a debt is discharged in a bankruptcy case, then it cannot be counted as income from debt forgiveness. Insolvency, which involves a situation when your assets have a fair market value that is less than the amount of all of your debts, also would exclude you from having debt forgiveness income. However, this is not easily determined so you would be wise to have a tax professional examine your financial position to determine if you are insolvent.
Another category of exclusion that is complicated and would require the help of a tax professional usually deals with certain farm debts. The IRS also has noted that non-recourse loans are not subject to debt forgiveness. These loans permit a lender to repossess the property that you financed with the unpaid debt or, if this does not apply, the property that you used as collateral in the event that you defaulted on the loan. There is no personal liability for the default on a non-recourse loan, which is why you do not gain taxable income from the debt’s cancellation. On the other hand, this type of loan still could result in a capital gain when the property is sold.
Exceptions should be applied before you apply the exclusions because their effects on “tax attributes” of yours are different. Unlike exceptions to tax forgiveness income, exclusions require you to reduce tax attributes, which include certain credits and losses as well as the basis of assets. Remember that, while income due to debt forgiveness can seem to be a relatively simple concept, there are many twists to this concept of which you must be aware, and the only way to approach this is to consult with a tax professional about all of the implications that ultimately will impact your tax bill.
There is one final word of caution when the possibility of income from debt forgiveness exists. Whether or not a Form 1099-C was received does not determine income tax implications. The IRS requires these forms only under certain circumstances. When a creditor cancels a debt of less than $600, you may not get a Form 1099-C. However, you must look at the possibility that you received income that is taxable due to debt forgiveness despite the absence of the 1099-C because the IRS would look for income in this situation and will not be do forgiving if you neglected to pay tax that you owed.