Don't let anyone tell you that debt forgiveness is a happy event, while paying taxes is not. The contrast is not that stark, and the truth lies somewhere in the middle.
Questions of debt forgiveness versus taxes often require financial savvy and fiscal dexterity as well as a diplomatic bent and an eye for detail. Understanding these topics is important, especially when it comes to managing your long-term retirement plan and complying with Internal Revenue Service stipulations. To familiarize yourself with everything at the crossroads of debt forgiveness and taxation, seek the expertise of professionals and listen to their different viewpoints to answer any tax question you might have.
What Is Debt – and When Does It Become Forgiven?
We are not covering the concept of "moral debt" here, the kind of obligation you must fulfill when you give your word to, say, a friend or family member. But the concept of financial debt is pretty similar to a moral obligation. You owe someone or an organization if you received money from the individual or company and promised to repay the debt at a specified date. You also owe if you promise to perform a service at a specified moment or over several periods, say, months or weeks.
If you have a debt, you are a debtor or borrower, and the person or company you owe becomes the creditor or lender. Debts run the whole gamut, from credit card balances and student loans to mortgages and personal loans.
Debt forgiveness, or debt relief, means a lender has stopped asking a borrower for money that was owed and should have been repaid in accordance with the loan's terms and conditions. Myriad factors can prompt a creditor to forgive a loan, including the borrower's bankruptcy or temporary default.
Note, though, that a creditor typically resorts to various techniques before absolving a debt. These include debt counseling, collection calls, settlement proposals, and consolidation suggestions. The lender loses money by excusing a borrower's debt, so it makes sense that the creditor goes through specific stages before making a final decision on debt forgiveness.
Is Forgiven Debt Considered Income?
The Internal Revenue Service and states' fiscal authorities consider forgiven debt as income. That makes sense because you may have used the loan money to, say, improve your welfare or advance your business objectives in the first place. So by not reimbursing the cash and keeping the goods you bought with the loan money, you are actually better off – as if you got free money from someone. Well, there's no such thing as free money; even lottery earnings are taxed.
Let me give you an example to further explain. Say you applied for a $1,000 personal loan, and, after approval, you used the loan proceeds to buy everything from your favorite clothes and jewels to brand-name shoes and eyewear. Several months later, you face economic tumult and cannot repay the debt, but you keep the goods. In this case, you are enjoying the benefits derived from goods that you did not pay for with your money in the first place.
Another way, more financially focused, to understand this is to say that debt forgiveness reduces your overall liabilities and increases your net worth, so it should be treated as income. (Net worth, or personal equity, equals your total assets minus total debts.)
Understand, however, that you don't have to report cancelled debt as income if the liability is the mortgage on your main home.
Do Lenders Report Forgiven Debt to the IRS?
Yes; if a lending institution cancels your debt, it will send you at year-end a Form 1099-C (PDF), Cancellation of Debt. The IRS mandates that you include the discharged debt amount in your gross income unless you fulfill an exception or exclusion. Pay attention to what's indicated on the Form 1099-C and make sure it is accurate, complete, and in sync with what you discussed with the lender or debt relief agency. The last thing you want is to pay income tax on debt you never had nor refused to pay.
Go through each line on Form 1099-C, but keep an auditor's eye on items 1 through 5. (See below for explanations)
- Date of identifiable event
- Amount of debt discharged
- Interest included in amount of debt discharged
- Debt description
- Whether or not the debtor was personally liable for repayment of the debt
Are All Debt Cancellations Taxable Events?
The IRS provides a detailed list of discharged debts that don't qualify as taxable events. Anything else on that list meets the income requirements, and you must report it as part of your gross income.
Debt cancelation that is not taxable:
- Liability discharged in a Title 11 bankruptcy case
- Debt excused because of insolvency
- Forgiveness of eligible farm debt
- Forgiveness of eligible real estate business debt
- Cancellation of eligible principal residence liability – that is, if your mortgage is discharged
- Forgiveness of some eligible student loans
- Amounts legally excluded from income, such as bequests and gifts
- Discharged debt that would be deductible if the borrower paid it off
Pay attention to your spending to make sure you don't bang your head against financial concrete by owing more than you can afford to repay. Remember that living within your means can help you plant the seeds of long-term economic freedom. Even if you cannot repay your debt and the lender ultimately discharges it, you still have to deal with the taxman and pay income on that cancelled debt. Either way – and this is my final point – you will repay some portion of the debt, be it to the IRS or the initial creditor.