When someone forgives a dept you owe, you may breathe a sigh of relief, believing you are off the hook. But you may not be free of your obligation to the Internal Revenue Service. When you borrow money and then the debt is forgiven, the IRS views the amount of debt you haven't repaid as income. Most forgiven debt is considered income for tax purposes, with a few exceptions. If you meet one of these exceptions, you’re required to report the amount of the forgiven debt to the IRS, but you won’t owe taxes on the amount.
Debt as Income
The IRS considers debt you don't have to repay as income, as if you'd earned money working or been presented with a cash gift. The amount of the forgiven debt increases your gross income and, depending on the amount of debt forgiven, could move you into a higher tax bracket. You report the debt with other income on your tax forms and figure your tax payment based on your adjusted gross income. Only in special cases may you exclude forgiven debt from your income.
If any of your debt is forgiven, your lender must send you a Form 1099-C, Cancellation of Debt, which shows the amount of debt forgiven. Use the information on this form to fill out a form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. You must include this form with your federal tax return. If your forgiven debt does not qualify for exclusion, report the amount of the debt, as indicated on the Form 1099-C, on line 21 of Form 1040. Report the amount on Schedule C if the debt is related to your business, on Schedule F if it is a farm debt or on Schedule E if the debt is related to non-farm rental property.
The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude from income any debt forgiven as the result of a home mortgage modification, foreclosure or short sale. The home must have been your principal residence for two of the previous five years. If you took cash out of the original mortgage for a purpose other than home improvement (such as to buy a car or to pay off other debt), that portion of the forgiven debt has to be reported as taxable income. Finally, the amount forgiven can’t be more than $2 million for a married couple filing jointly or $1 million for an individual.
Insolvency and Bankruptcy
The IRS also allows you to exclude from taxable income debt forgiven as part of bankruptcy proceedings or if you declare insolvency. The IRS considers you insolvent if your liabilities exceed your assets. You can complete the IRS’s Insolvency Worksheet to determine if you qualify. If you file bankruptcy, any debt cancelled by the court may be excluded from income tax.
Student Loan Debt
If you agree to perform a certain kind of work, or to work in a certain area, in exchange for forgiveness of all or part of your student loan, you don’t have to pay taxes on the amount of your debt that is forgiven. For example, some doctors, teachers and other professionals may have their debt forgiven if they agree to practice in underserved areas, or to work for certain charities.
Before you accept forgiveness of a large amount of debt, you may want to consult a tax professional about the tax implications of accepting the debt forgiveness. Though you'll be free of paying off your loan, you could end up owing a significant amount of money to the IRS, depending on the size of the debt forgiven and your tax situation. Figure how much the debt forgiveness will increase your income for the year and consider whether you qualify for any exceptions that will relieve you from paying taxes on the forgiven debt.
- Comstock/Comstock/Getty Images