If you’ve managed to have debts forgiven or canceled, or you’ve settled with a creditor for less than what you owe, you no longer have to worry about those monthly payments.
You may, however, have to worry about paying taxes on the forgiven amount. Borrowers who have had their debt forgiven still must pay income taxes on it, with few exceptions.
If you’ve recently had a debt discharged, it’s important to know whether it’s taxable and what to do to prepare for the tax bill.
When Forgiven Debt Isn’t Taxable
“More often than not, if you’ve had debt forgiven by a creditor — even if only in part — the amount of your debt forgiveness will be taxable, unless you qualify for an exemption,” says Logan Allec, a certified public accountant based in Santa Clarita, California, and creator of the personal finance site Money Done Right.
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Depending on the type of debt and the circumstances of its discharge, you may be able to reduce its impact on your tax bill or eliminate it altogether. Here are some examples:
The debt was discharged in a bankruptcy. If your financial situation is dire and you choose to file for bankruptcy, any debts that are discharged by the court in your case are not considered taxable.
“The idea is that if you’re going through bankruptcy, your life is already in shambles,” says Jeffrey Schneider, head of Florida-based SFS Tax & Accounting Services. “They’re not going to slap you again by putting a tax liability on you.”
You’re insolvent at the time of the cancellation. If you’re settling with a creditor for less than what you owe because you can’t afford your payments, the idea of paying taxes on the forgiven amount can be discouraging.
Fortunately, being broke may reduce or eliminate your tax bill on the canceled debt. The IRS considers taxpayers insolvent if their liabilities exceed their assets. If you qualify, you may be able to exclude part or all of the forgiven debt from counting as income.
If you believe you qualify under the insolvency exclusion, you’ll need to write down the fair market value of your current assets and liabilities, based on what they were immediately before the debt was discharged. Make sure to include your retirement plan in your asset calculation, says Schneider.
Once you’ve tallied everything up, subtract your assets from your liabilities. If the result is zero or negative, you’re not insolvent and may be on the hook for the full amount. But if your liabilities exceed your assets, you may be able to exclude some or all of the discharged balance.
For example, say your liabilities, including your forgiven debt, are $15,000 and your assets are worth $9,000. In this case, you’re insolvent to the extent of $6,000. If your forgiven debt totals $5,000, you can exclude the full amount because it falls below your insolvency amount. If, however, your forgiven debt totals $10,000, you’d only be able to exclude $6,000 of it as income because that’s the extent of your insolvency.
Allec recommends working with a tax professional if you think you qualify for an insolvency exemption.
The debt qualifies under a business or farm exclusion. If the canceled debt was attached to your farm or real estate business and you meet other qualifications, the discharge amount qualifies for a special exclusion.
The canceled debt was a gift. If you borrowed money from family or friends and they decide not to collect the full amount, the IRS considers the forgiven amount a gift and won’t require you to include it as income.
The same goes if you no longer owe the debt as a result of a bequest or inheritance.
The interest amount would have been tax-deductible. If your forgiven debt included tax-deductible interest, such as for a business loan or mortgage, you don’t need to report the interest amount as income because it would have been deductible anyway.
You will, however, still be on the hook for the canceled principal amount of the loan.
Student loans forgiven based on service. Student loan debt that was canceled through programs like the federal Public Service Loan Forgiveness program, which require the borrower to work in a particular field for a set period, is not considered taxable income.
Note, however, that this is not the same as student loans forgiven under federal income-driven repayment plans, which adjusts your student loan payments to your income for 20 to 25 years. When a borrower reaches the end of an income-driven repayment plan, any remaining balance is forgiven, but the forgiven amount is subject to taxes.
Student loans discharged because of death or permanent disability. The U.S. Department of Education and some private lenders will forgive your student loan balance if you die or become permanently disabled. Under the Tax Cuts and Jobs Act, this canceled debt will not be considered taxable income through 2025.
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How to Account for Forgiven Debt on Your Tax Return
It’s possible that you won’t realize the tax implications of your forgiven debt until you get something in the mail about it. “Taxes aren’t on most people’s radar unless they actually receive some kind of cash payment,” says Allec.
If you’ve had a debt of $600 or more discharged by a creditor, the creditor is required to send you a 1099-C IRS tax form for that year, showing how much was forgiven. In most cases, this is the amount you’ll need to include in your gross income when filing your tax return.
Even if your situation qualifies for an exclusion of the rule, you may still get a 1099-C form. If this happens, you’ll use Form 982 to report the amount and state how much should be excluded from your gross income based on your circumstances.
Once you’ve determined how much of the canceled debt should be included as income, add the amount to Form 1040, Schedule 1 on line 21 as “other income.” It will then be included in your gross income for the year.
What to Do to Prepare for a Tax Bill on Forgiven Debt
It’s best to plan ahead for taxes as soon as your debt is forgiven. And if you receive a 1099-C tax form, don’t ignore it. If your gross income on your tax return is different from what’s been reported to the IRS, that can raise questions and could trigger an audit.
“Even if the amount is less than $600 and a Form 1099-C is not received, the taxpayer is still required to report this income on their tax return,” Allec says.
Consider working with a tax professional to get an idea of how much more you might owe with the added income. If you’re not sure you can pay your bill, it’s still best to file on time. The IRS charges a failure-to-file penalty of 5 percent of the amount owed, for each month that your return is late, up to a total of 25 percent of your unpaid taxes.
“I always tell people file and don’t pay, and we can work out the payments later,” says Schneider.
Types of IRS Installment Agreements
The IRS offers two types of installment agreements: short term and long term. The short-term plan is designed for taxpayers who can pay what they owe within 120 days. There’s no fee to set up a short-term installment plan.
If you need more time, a long-term installment plan can extend past 120 days. Depending on the type of payments you choose and your income level, it can cost between $31 and $225 to set up the plan.
Under either option, the IRS will charge both interest and a failure-to-pay penalty until you’ve paid your bill in full.
As of March 2019, the interest rate is 6 percent annually, and the failure-to-pay penalty is 0.25 percent per month or part of a month in which you have a remaining balance, once the installment plan goes into effect. That said, these charges are less than the penalty for not filing your return.
What to Do If You Paid Taxes on Debt That Qualified for an Exclusion
If you’ve had a debt forgiven in the past that you now realize is eligible for an exclusion, you don’t need to worry about losing that money forever. The IRS allows taxpayers to amend previous years’ tax returns for up to three years.
To do this, gather all of your existing tax documents from that year and file Form 1040X, which is an amended tax return. In the process, make sure to include Form 982, explaining the exclusion you qualify for and how much should be excluded. Then, submit your amended tax return by mail.
The Sooner You Start Preparing, the Better
If you’ve recently had a debt canceled, start preparing now for how it will affect your taxes. By not procrastinating, you can determine early on how much you’ll need to save, if anything, and start working toward your goal.
If you wait until the last minute, you will not only be more stressed but may also be on the hook for interest and penalties as you pay off what you owe over time.
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