You have to pay taxes on your canceled debt
By Michelle Singletary
By Michelle Singletary
WASHINGTON — If you're working with a creditor to forgive some of your debt, there's something important you should know.
Any debt that is canceled could create another bill — a tax bill.
"I am a tax preparer with a very large tax-preparation company and have had to deal with unhappy taxpayers who are upset to find they have a tax liability they did not expect," said Larry Cohen, a senior tax adviser at an H&R Block office in Wheaton, Md.
Cohen's remarks were prompted by a recent column I wrote about whether debtors should accept a settlement. That column was the first of several on the issue of debt collection. This second installment deals with an important downside of debt dealing.
Cohen remembers one client he tried to help after her consulting business failed. The woman had been living on her credit cards and eventually amassed about $30,000 in debt. She was able to negotiate that debt down to about $10,000, Cohen said.
But the cancellation of debt created a $5,000 federal tax bill.
"When I told her she would have to pay taxes on the $20,000 that was forgiven, she was absolutely flabbergasted," Cohen said. "She was just completely upset. She just ran out of the office. She didn't even pay me."
Cohen and other experts say borrowers often aren't aware of the tax implications of debt cancellation, which can also trigger a state tax debt.
If some of your debt is forgiven as a result of a car repossession or renegotiated credit card or mortgage debt (often the result of a foreclosure), you should receive IRS Form 1099-C "Cancellation of Debt" or 1099-A "Acquisition or Abandonment of Secured Property."
Only certain institutions are required to send borrowers a 1099 if debt is forgiven. They include federal government agencies, certain agencies connected to the federal government, financial institutions, finance companies or credit unions. The agency or institution is supposed to send a 1099 if the canceled debt is more than $600. However, other creditors can and do voluntarily submit the forms to the IRS.
And no, the tax obligation doesn't go away if the creditor fails to send you the form at the end of the tax year. Although you didn't get a 1099, it's possible the creditor sent one to the IRS. The settled debt should be reported on your 1040 tax form.
You may also have to pay income tax on any interest that is forgiven. For more details about what interest is taxable, read IRS Publication 525 (skip to the section on canceled debt).
But some canceled debt is not considered taxable income. For example, the cancellations of qualified farm debt, certain student loans and debt discharged in a Chapter 11 bankruptcy are not taxable. In the case of student loan debt, if your loan is forgiven in part or full, you won't have to pay those taxes if you promised to work for a certain period of time in certain professions.
There's also a provision of the law that excludes canceled debt if you're insolvent, meaning your liabilities exceed the fair-market value of your assets. But trust me, the insolvency exception is complicated and you should seek professional help.
There are two other IRS publications you can read to find out more about cancellation of debt: IRS Publication 17 "Your Federal Income Tax" (go to page 12) and IRS Publication 908 "Bankruptcy Tax Guide" (skip to page 21).
For many debtors, having to pay income tax on canceled debt seems so unfair, especially if they've suffered a financial hardship. But is this tax rule that unjust?
When you get a loan to buy a home or car, or use a credit card to pay for goods and services, that capital isn't considered income because you have to pay it back.
Hardship or not, didn't you live in the house? Didn't you drive the car? Didn't you use, wear or eat the items purchased on credit?
If you don't pay back the loans, haven't you enriched yourself at the expense of the creditor?