Getting something you expected to pay for at a deep discount or even for free is exciting. In the case of forgiven debt, however, you may learn the deal wasn’t quite as good as you thought.
If a business canceled some or all of a debt you legitimately owe, you may have to pay income tax on the forgiven sum.
Here’s when a forgiven debt can trigger an extra income tax obligation, and how to deal with it if it does.
[I Have to Pay Taxes on That?]
What Is Forgiven Debt?
When you borrow money from a financial institution, you and the lender enter into a contractual payment arrangement. If you receive services from a business such as a dentist or utility company, you’ll get a bill for the services they provided. If you don’t pay the bill, a debt collector may purchase the unpaid account, and you’ll then owe that company.
[READ: What Is a Debt Collector, and What Do They Do?]
Whether the debt is with the original company or a collector, it may be possible to have all or a portion of it canceled, or forgiven. In that case, you’ll no longer owe the money to that lender, company or agency.
For instance, a collection agency may have acquired a hospital bill totaling $8,000. After negotiating with the collector, you were able to convince them to accept a lump sum of $1,000 to consider the case closed. After that, neither the hospital nor the collector can come after you for the $7,000 differential.
Forgiven Debts That May Be Taxable
As wonderful as it can be to have all or some of your debt wiped away, in some cases the IRS considers the forgiven amount income. Consequently, says Karla Dennis, an enrolled agent in La Palma, California, you may have to pay income taxes on that amount.
Examples of forgiven debt that can trigger a taxable event are:
— Reduced loan or credit card balance.
— Settled collection agency debt.
— Canceled bills for services rendered, like medical care.
[How to Negotiate Debt With Your Credit Card Company]
Imagine you settle a bill resulting in a $7,000 forgiveness. You would add that figure to your other sources of income on that year’s tax return. Therefore, if your tax rate is 22%, you might pay an additional $1,540 in taxes. But the forgiven debt pushes your total taxable income to a higher tax bracket.
As an individual you can settle a debt on your own, so you may not know about the tax issue. However, if you used a debt settlement company to negotiate the balance, it should inform you that the forgiven amount will be considered taxable income.
Get Ready for IRS Form 1099-C
“When you have a debt canceled, be on the lookout for a 1099-C,” Dennis says. It’s the IRS form the company will issue to people who have had their debts forgiven, whether completely or partially.
Creditors will send out Form 1099-C when the forgiven debt is $600 or more. Even if it falls under that threshold, if it qualifies as taxable income you are still required to report it on your return.
You may not get the form right away, though, so be proactive. Add the forgiven sum to your income whether you received the 1099-C or not.
“When it comes to tax situations, forms don’t always come out timely, especially when we’re in recessionary periods,” Dennis says.
“I have seen situations where people have gotten their debt canceled in November or October of one year, and then won’t get the form until the end of the next year, after they’ve already filed their taxes,” she adds.
Forgiven Debts That Aren’t Taxable
The good news is that not all forgiven debt is considered a taxable event. For example, you won’t have to worry about the following canceled balances:
— Debts discharged in bankruptcy. After your debts are forgiven in bankruptcy court, they are gone for good. Those balances are not considered taxable income by the IRS.
— Settlement with the IRS. The IRS offers its own debt settlements – an offer in compromise – to certain financially stressed taxpayers. Income taxes will not be assessed on the forgiven portion.
— Canceled Federal student loans. The Public Service Loan Forgiveness program canceled many borrowers’ student loan balances.The IRS has made it clear thattwhose borrowers will not be assessed income taxes on the canceled portion of their debt.
— Nonrecourse debt. A nonrecourse debt allows a lender to claim only the collateral on a secured loan. If the value of the collateralized property depreciates, the lender can’t come after you for the cash value difference and the IRS will not consider that money taxable income.
The Insolvency Exemption
When you thought a debt was long behind you, finding a Form 1099-C in the mail can be alarming. It may not seem fair that you’re being penalized for catching a much needed financial break. Recourse, however, may be available.
According to Kemberley Washington, a CPA based in New Orleans, even if the forgiven amount is taxable you may have a way out of the extra cost with the IRS insolvency exclusion.
“A lot of people don’t know about the exclusion, and it can really help,” says Washington. “If you’re eligible, you can eliminate the taxable portion of your forgiven debt, which is good news for many taxpayers.”
As long as the total of your liabilities exceeded the value of your assets when your debt was canceled, you may claim the insolvency exemption. You still have to report the canceled debt as income on your return, but will file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to receive the adjustment.
Don’t Guess, Get Assistance
When you’re faced with any unexpected taxable event, including one from a forgiven debt, reach out to an expert for guidance.
If you don’t have a CPA or other tax professional at your disposal, look into all the ways you can get free tax advice. Mistakes can be costly, so don’t wing it and hope you did everything right.
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The Most Painful Tax Bill: Forgiven Debt originally appeared on usnews.com
