When finances become tight and you cannot repay your debts, you may be forced to find a way out of your financial liabilities and obligations. Seeking help through third-party debt negotiators, creditors and bankruptcy courts may result in cancellation of your debts. While you are no longer liable for payments on canceled debt, you may owe Uncle Sam a tax on discharged balances.
Forgiven Debts
A forgiven debt is any debt that you once owed but no longer owe, because your lender erased your liability. This could include foreclosure, repossession of a vehicle or canceled student loans. Additionally, many people receive negotiated credit card balances through third-party debt management companies. Using a third party company can result in lower interest rates on initial balances, waived fees and a lower credit card balance.
Taxes
According to the Federal Trade Commission and the IRS, you may have to pay taxes on the amount of any forgiven debt. Because you are no longer required to pay the lender the balance of your loan or credit account, you must report the forgiven debt as income. Referred to by the IRS as cancellation of debt, your lender will send you and the IRS Form 1099-C as a declaration of the amount of canceled debt. The amount is taxed the same as your other earned income on your federal income taxes.
Exceptions
You may not have to pay taxes on your forgive debt if you meet certain qualifications. For example, the IRS exempts any debt discharged by a bankruptcy court. Similarly, you may not owe taxes on part or all of any debts forgiven on the mortgage of your primary residence per the laws of the Mortgage Debt Relief Act of 2007. Other conditions for exemption include insolvency, farm debt and cancellation of debt on a non-recourse loan.
Reporting
You must report your forgiven debt when you file your annual federal income tax return by adding the amount of your forgiven debt to your gross income. However, if your canceled debts are eligible for exclusion from taxation, you must report the forgiven debt on Form 982 attached to your federal income tax return. On this form, you must note the type of debt forgiven, as well as in what manner it was forgiven. You can print this form from IRS.gov or order a copy by phone. Most tax software systems also provide the user with access to Form 982 when filing.
Getting Help
If you are having trouble repaying debt or making your minimum monthly payments, consider consulting with a nonprofit credit counselor that can help you find solutions to your financial problems. Check with your bank or credit union to see if they offer any free assistance, or you may be able to find free help at a local university, military base or U.S. Cooperative Extension Service branch. These counselors will help you come up with a budget that fits your needs, as well as offer you free information on money management.
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