Tax Time: Don’t Forget Forgiven Debt

Have you reduced your debt balances by negotiating a settlement with your lender? While this move undoubtedly saved you thousands of dollars, you are not yet free and clear of that debt. When a credit card company or other lender agrees to accept less than the balance owed on an account, the difference is considered “forgiven” debt. You are not obligated to pay the forgiven debt if you hold up your end of the bargain in paying off the agreed upon amount. If the difference between what you owed and what you paid exceeded $600, the lender will be reporting that amount to the IRS. In an ironic twist of fate, the very debt you couldn’t afford to pay off in full to the lender is now considered taxable income by the IRS. Here we look at how you can handle forgiven debt at tax time.

Documentation

Just as your lender is required to report canceled debt to the IRS, they are also required to send you proof of cancellation as well. This comes via Form 1099-C, Cancellation of Debt. You will need this document when you file your tax return, therefore you should be looking for it in your mailbox during the same time period other tax documents are arriving. If you do not receive a 1099-C from your lender, do not assume you have been given a free pass. Contact the lender to find out how you can get a copy of this document.

Insolvency exclusion

The IRS may consider forgiven debt taxable income, however not all filers will have to pay tax on the canceled debt. Assuming most individuals who qualify for debt forgiveness are going through a financial hardship, the IRS has an insolvency exclusion. Basically this means you may not have to pay taxes on the forgiven debt if you can prove you were insolvent at the time the debt was forgiven. In a nutshell, you must provide proof that at the time of the debt cancellation, your liabilities exceeded your assets. Individuals who were insolvent at the time the debt was canceled may not be responsible for paying taxes on that amount. In some cases a person might not have to pay taxes on the entire amount, but rather a portion of the forgiven debt.

Filing your tax return

Individuals with forgiven debt can still prepare their tax return on their own, or enlist the help of a professional tax preparer. In either situation, it is important to make sure the forgiven debt is handled properly to avoid an penalties or fees. If you are claiming insolvency, Form 982 will have to be filed and submitted with your tax return. Filers with questions regarding forgiven debt are encouraged to contact the IRS or visit a tax professional for assistance in preparing the return.