Taxation on Debt Relief

When borrowers are having trouble paying off debts, such as mortgages or credit card liabilities, they often seek some type of debt relief. Many forms of relief result in a restructuring of the loan. The lender agrees to change the terms of the loan and the borrower agrees to resume payment with the newer, easier schedule. Often, the negotiations include some type of settlement when the lender agrees to forgive a portion of the debt owed. This results is taxation issues for the borrower.

Debt Cancellation

When a debt is entirely removed without being repaid, it is known as debt cancellation. Lenders may forgive a portion of credit card debt if the debt is old, unlikely to be repaid in full, and borrowers agree to pay off at least a fourth of the debt in a lump sum. A short sale is another common example of lender-debt forgiveness. A short sale uses the proceeds of a house sale to cover a mortgage debt, but many times the proceeds are not enough. In this case, the lender may choose to simply cancel the remaining debt and close the account.

Taxation Practices

The problem with this type of debt relief is that it essentially releases income that the debtor would have otherwise owed. From the perspective of the IRS, this is the same as making income, and the IRS will require that the forgiven debt be taxed as extra income for the year in which it was cancelled. This means that debtors will have to accept higher future tax payments in return for ending the debt in this way. Common income tax rates apply to these sums based on the debtor's other financial circumstances.

Specific Exceptions

The federal government can create exceptions to this taxation rule. One famous exception was included in the Mortgage Debt Relief Act of 2007, which was extended through 2010 to apply to mortgage debt forgiven by lenders in processes like a short sale. To help bolster a crashed housing market, the government cancelled any required taxes from forgiven debt. Debtors were required to have the debt apply to a principal residence that was bought using the mortgage because the cancelled debt was made exempt.

Bankruptcy Exception

There are other, more permanent exceptions to the taxation rule based on the debtors' finances. For instance, a bankruptcy will also cancel debts but these debts are not taxed in the same way. In fact, if a borrower is in a bankruptcy status then all forgiven debt can usually be written off because of insolvency when filing a tax return.