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Bankruptcy or debt cancellation? There are tax consequences

On Behalf of | Nov 6, 2020 | Tax Controversies |

This year, a lot of people are facing financial troubles. The good news is some lenders have been willing to work with debtors to relieve some of their debts. Unfortunately, that could result in a taxable event.

Generally, debt that is freely forgiven, such as through a negotiated settlement, is considered income. And, that income may be taxable.

For example, suppose you were forced to sell your home in a short sale. The mortgage holder may have agreed to accept the price you were given in full repayment. Sometimes, this is done because the difference between what you owe and what you can pay is less than the cost of foreclosure.

That remaining balance on your mortgage that was forgiven? It is considered income. Similarly, you may have negotiated a settlement of your credit card debt for less than the full amount. The IRS considers that remainder to be income attributable to you.

That income is not always taxable. However, it is likely you will get a tax form called a 1099-C, Cancellation of Debt, from the lender who forgave the debt.

Before you assume you must pay taxes on that “income,” consider that it may not be taxable. Here are some situations where it generally wouldn’t be:

Cancellation of the debt was through bankruptcy (Chapter 7, 11 or 13). Your cancelled debt is not taxable. If you receive a 1099-C for that debt, you should attach form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

You were insolvent just before the debt was cancelled. If this was the case, you can exclude the income from taxation by using the insolvency worksheet (Publication 4681, Cancelled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals)).

The cancelled debt was for your qualified principal residence. If you received forgiveness on your home mortgage, the cancelled debt may not be taxable. The mortgage must have been on your main home and you cannot have been forgiven more than $1 million ($2 million for married couples filing jointly).

Student loan debt was canceled due to death, eligible service or permanent, total disability. If you have been working off your student debt by working in public service for a period of time, you don’t owe taxes once the debt is forgiven. Similarly, if your loan is forgiven due to your death or a permanent, total disability, you probably won’t owe any taxes.

Before you attempt to exclude forgiven debt income from your taxable income, you may want to discuss your situation with a tax attorney. There could be issues you are unaware of, and you should not take this blog post as legal advice.