Receiving notice that a creditor is forgiving a debt can be a celebratory moment, until you realize the Internal Revenue Service typically considers forgiven debt income and expects you to pay taxes. Creditors who forgive a debt must send the debtor a Form 1099-C to be able to claim the write-off as a loss. Unless you qualify for an exemption, this can lead to serious tax consequences for you.
Mortgage Debt Forgiveness
As of 2011, the IRS does not tax debt if the lender writes off debt from a mortgage or a foreclosed home, provided the debt is less than $2 million for spouses filing jointly and less than $1 million if you file as a single person. Forgiven debts from a mortgage loan restructure also qualify for this exemption. The mortgage debt must be from your primary residence and cannot be payment for services you provide for the lender. Unless extended by Congress, this exemption expires in 2012, according to the IRS.
Bankruptcy and Insolvency
Filing bankruptcy allows taxpayers to avoid taxes on forgiven debt in most circumstances. If your amount of debt is more than your total assets -- excluding the amount your state allows you to exempt in a bankruptcy proceeding -- you are not liable for taxes on the forgiven debt. The same exemption applies if you can prove insolvency, even if you do not declare bankruptcy. For example, if your forgiven debts total $100,000 and your assets total $75,000, you will not have to pay tax on the $25,000 difference.
Student Loans
You do not have to pay taxes on forgiven student loans if you receive forgiveness after meeting certain work stipulations imposed by your state or federal government. Teachers, doctors and nurse practitioners often take advantage of programs that require them to work in rural or depressed areas to receive forgiveness of their student loans. Debt forgiven in these cases is not taxable as income. The debt is taxable as income if the lender forgives the debt due to default.
Interest
If the interest on a loan would have been a deduction from your taxes, you do not have to include it in the debt as taxable income. For example, if a lender forgives a business debt that includes interest, you can subtract the interest if the lender does not. Your Form 1099-C should list the total amount forgiven in box 2 and the interest amount in box 3. Only report the difference of the two amounts as income for tax purposes. Personal credit cards do not qualify for this exemption. However, mortgages do if you are not able to write-off the full amount because mortgage interest is tax deductable.
Considerations
You may be responsible for taxes on debts even if the lender only writes off part of the debt. If you negotiate the amount of your debt to a lower amount or you settle your debt with your lender for less than you owe, your lender will typically send you a Form 1099-C for the difference. The IRS provides Form 982 for taxpayers to exclude forgiven debts from your income.
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