In general, if you owe money and it’s eventually written off, as far as Uncle Sam is concerned, the destroyed debt is taxed like income. This might not seem fair. After all, it’s not like you got a check. The forgiven debt is more like a gift, and gifts aren’t taxable. So why would the IRS treat this forgiven debt as income? The logic lies in the way income and losses are treated for tax purposes. Basically, it’s yin and yang: One man’s deduction is the other man’s income. When it comes to business, most transactions involving money are deductible to the one paying it and income to the one receiving it. For example, if a bank pays interest on your savings account, they get to deduct that money as an expense on their taxes – and you count it as income on yours. And if the bank lends money you don’t pay back, the bank deducts the bad debt as an expense – and you have to include it in your income. In short, the term “debt forgiveness” makes it seem like a gift, but it’s more like “debt deduction.” When one party is writing something off, the opposing party is typically reporting it as income. That’s the rule and the logic behind it. But as with many rules, especially those relating to income taxes, there are many exceptions. Let’s look at a few:
Insolvency – According to IRS publication 4681, if you’re “insolvent,” meaning you owe more than you own, forgiven debt isn’t counted as income. Their words… Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV (Fair Market Value) of all of your assets immediately before the cancellation. To qualify for this exclusion, you file Form 982. This is generally the form people file when they enter into debt settlement agreements like Mike’s and will probably be his best chance at avoiding paying taxes on his forgiven debt.
Bankruptcy – Debt cancelled through a Chapter 7 or Chapter 13 bankruptcy typically isn’t taxable.
Mortgage debt – A foreclosure often includes cancelled mortgage debt – the amount of the mortgage not recouped when the home is taken back and resold. Since that results in forgiven debt, the result for many hapless homeowners is losing their home, then months later getting a tax form in the mail informing them they owe taxes on potentially hundreds of thousands of dollars of income they never received. Depending on state laws, the same could be true for those doing a short-sale (selling their home for less than the mortgage balance) or participating in a program like Bank of America which recently cut qualifying mortgage holder’s balances. Talk about salt in the wound! Fortunately Congress rode to the rescue years ago and passed a law called the Mortgage Forgiveness Debt Relief Act of 2007. This law applies to homeowners whose mortgage debt is “partly or entirely forgiven during tax years 2007 through 2012.” You can read the details at this page of the IRS website, or by reading Publication 4681. But in general, if the forgiven mortgage debt was less than $2 million for married couples ($1 million for singles), was secured by a principal residence (as opposed to a rental property or vacation home), and was used to purchase or improve the home (as opposed to buying a car or paying off credit cards), it’s not reportable as income.
The aforementioned are some common exceptions that could help you avoid taxes on forgiven debt, but they’re not the only ones. There are also different rules for businesses, as well as for debts that are recourse (those for which you’re personally liable) and non-recourse. State laws can also play a part, and so can other laws. For example, after hurricane Katrina, Congress passed a law allowing those in affected areas to exclude forgiven non-business debts from their income that year. Paying people to do things you can do yourself is not desirable but experienced professionals could be worth paying for. Publication 4681 (2011), Canceled Debts, Foreclosures, Repossessions, and Abandonments is 26 pages long and the amount of detail therein combined with the amount of money involved could warrant seeking advice/assistance, preferably before you agree to settle the debt. [MoneyTalksNews Stacey Johnson article 29 May 2012 ++]
Late last month Representative Scott DesJarlais (R-TN) introduced H.R.5044, the Andrew P. Carpenter Tax Act. The bill forgives the income taxes due that are added when a deceased servicemember’s student loans are forgiven by the loan holder. Ordinarily, student loans are categorized as gross taxable income for families of veterans who have lost their life while serving on active duty in the United States Armed Forces. The drive to correct this injustice came from the story of Lance Corporal Andrew P. Carpenter of Columbia, Tennessee, who lost his life on February 19, 2011, while serving his country in Afghanistan. Three years prior, Andrew had taken out a private educational loan. After learning that he had been killed in action, the company administering the loan agreed to completely forgive the debt. Upon forgiveness of the debt, the family received a 1099-C form from the Department of Education informing them that the debt discharged would be factored into their gross taxable income for that year.
“I am humbled to have the honor of working with the Carpenter family to introduce this legislation,” said Representative DesJarlais. “It is a fitting way to fix a glaring problem in our tax code, while paying tribute to the memory of Lance Corporal Carpenter. His family has experienced the pain of losing their son, husband and father. Hopefully, if passed this measure will in some way ease this burden.” It is important to note that this bill would not make it mandatory for private lenders to forgive education loans. Private loan companies would still have the option of whether or not to forgive a loan, and federally backed loans are already forgiven for deceased veterans under the Higher Education Act. This legislation would simply prevent the IRS from collecting taxes on any amount of loan forgiveness. The Andrew P. Carpenter Tax Act would have a retroactive effective date of October 7, 2001, the start of Operation Enduring Freedom. The bill already has 20 cosponsors, including LTC Allen West (R-FL, USA-Ret.) and Sgt. Major Tim Walz (D-MN, USA-Ret). [Source: TREA News for the Enlisted 1 Jun 2012 ++]