Cancellation of debt is normally a good thing, since it means you can pay a creditor less than you owe. Unfortunately, there is often a downside to the cancellation of debt. In certain situations, the cancellation of debt can result in additional financial problems, particularly if you are unaware of the consequences. At other times, such as in the case of a bankruptcy discharge, you may be able to sidestep the taxation of your cancelled debt.
Tax Rules Regarding Forgiven Debt
Generally speaking, if you are the beneficiary of any type of forgiven debt, including credit card debt or mortgage debt, you must include the amount of the cancelled debt in your gross taxable income. From the perspective of the IRS, receiving money that you do not pay back is usually considered income. If you fail to repay a loan, that qualifies as income because you received income in the form of the loan that you did not pay back. This can cause serious financial problems, since it is unlikely you have a large amount of money available for your tax bill if you couldn't afford to pay your loan back in the first place.
Realizing that the collapse in home prices was already creating serious financial difficulties for some homeowners, in 2007 Congress passed the Mortgage Forgiveness Debt Relief Act. Essentially, this piece of legislation waived the tax consequences for lender-cancelled debt for certain homeowners. Specifically, the exemption applied to homeowners who had up to $2 million in debt forgiven on their principal residences for years 2007 through 2012. For this small window only, you could avoid having to pay tax on certain cancelled debt.
In order for the IRS to be aware that you owe taxes on a transaction, someone has to report it to the IRS. If your lender forgives or cancels some or all of your debt, it will report this to the IRS using Form 1099-C. Your lender should also send you a copy. A 1099-C is basically an informational form showing the amount of the debt the lender cancelled. Assuming the information is correct, you must report the amount on your Form 1040 when you file your taxes, so that it can be included in your taxable income.
Bankruptcy and Taxes
One way around the taxation of cancelled debt is to file bankruptcy. If the bankruptcy court grants you a discharge, it is a non-taxable event. Even if you discharge $300,000 in debt, you will not have to pay tax on any of it. Your creditors may still send you a 1099-C, but it should show that your debt was not cancelled but rather included in a bankruptcy discharge.
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