What Is Forgiven Debt?

When a creditor forgives a debt, many consumers are surprised to find that they still owe money because of the unpaid loan. Forgiven debt can trigger income tax, which is far harder to evade than most private loans. Depending on your financial situation, you might be able to convince a creditor to cancel a debt and avoid tax obligations on it.

Identification

Forgiven is debt is any money owed to a creditor that the creditor cancels because the borrower cannot pay it. Credit card companies often do this as part of a settlement. The card issuer might, say, agree to cancel $8,000 on a $10,000 balance if the borrower comes up with the $2,000. Most debts that are canceled are unsecured. Secured loans are backed backed by collateral, such as real estate, and cannot be discharged via bankruptcy, so the creditor rarely has a reason to forgive the debt.

Misconception

The Internal Revenue Service considers forgiven debt income because it is "earned." The theory behind forgiven debt as income is that it increases your available resources for other use. This means that the IRS charges income tax on the canceled portion of a debt. For example, if a creditor cancels $5,000 on a $10,000 loan, the borrower adds $5,000 to his taxable income. The tax obligation on forgiven debt depends on the tax bracket. That $5,000 taxed at 10 percent would mean the taxpayer owes as much as $500 on the canceled debt.

Tax Forms

If a creditor forgives a debt, it will send you a 1099-C for miscellaneous income when the total amount of forgiven debt on a loan exceeds $600. In some cases, you can avoid paying tax on forgiven debt all together. Debt forgiven via a bankruptcy discharge is nontaxable. You can also avoid forgiven debt income by proving insolvency to the IRS. In general, you are insolvent when your debts exceed the value of your assets before the cancellation of the debt. The IRS requires taxpayers to include Form 982 with their tax returns if they want to exercise the insolvency exclusion.

Warning

You should probably go to a tax professional if a creditor forgives your debt and you want to declare insolvency. Proving the fair market value of your assets and which assets should be included in your net worth can be difficult, especially when you own securities like stocks that have a constantly changing value.