Once you reach a settlement agreement, there are key steps you need to tax if you want to avoid income tax liability on the canceled debt
19 min read
“I’m being taxed on what?!”
Most taxpayers know they pay income tax on their wages, or if they sell stock, or sell a house. However, many are unaware that the IRS also levies income tax on canceled debts. The IRS treats canceled debt as taxable income, which increases your tax liability. Unless you take action, you could be paying taxes on the debt you didn’t pay back during your settlement.
IRS will exclude canceled debt if the discharge occurs for:
The two most common situations are when the taxpayer is insolvent and for qualified principal residence indebtedness. The IRS considers a taxpayer when their total liabilities exceed their total assets.
Applying for the insolvency exclusion involves filling out a form detailing all the taxpayer’s liabilities and assets (see IRS publication 4681). The IRS allows taxpayers to exclude canceled debt in an amount equal to how much their liabilities exceeded their assets.
For example, if a taxpayer has $10,000 in liabilities and $7,000 in assets, that taxpayer can exclude the difference; they qualify for forgiveness for up to $3,000 in canceled debt. The tax on $3,000 could up to almost $1,200. So, claiming this exclusion can make a big difference on the tax return’s bottom line.
The second most common canceled debt exclusion is for qualified principal residence indebtedness. A qualified principal residence is your “primary home” that you live in most of the time. This type of cancellation most commonly happens when the lender agrees to a short sale or starts a foreclosure action.
Until 2016, IRS allowed an exclusion of up to $2,000,000 in canceled mortgage debt arising from foreclosure or short sales of taxpayers’ principal residences. This exclusion allowed the vast majority of taxpayers forced into foreclosure or short sales to escape the “double penalty” of a tax bill for any unpaid mortgage debt.
However, beginning in 2017 the IRS dialed back the exclusion. Now, the IRS now only allows the exclusion if the discharge was “subject to an arrangement that was entered into and evidence in writing before January 1, 2018” (See Instructions to form 982). So, while this provision has provided immeasurable relief over the past 10 years, it may not exist much longer.
People often think forgiveness on loans or credit card debts is the end of your troubles. You paid as agreed, so you can breathe easy. But once you’ve settled debt and it’s been discharged by the creditor, lender or collector, your work isn’t done.
The income tax levied on canceled debt can be a serious burden for taxpayers already in financial distress. You wouldn’t be settling debt and taking credit score damage if you had the means to pay. So, it’s critical to file your taxes correctly for any years where you settle a debt.
By knowing which types of canceled debt income you can exclude and by properly claiming it on your tax return, you can reduce or eliminate the “double penalty”. However, you must know how to file canceled debt on tax return forms to avoid liability.
The key is to have an experienced tax preparer on your side. You need someone to guide you through the process and ensure you are not overpaying. Without guidance, it is easy to fall prey to the “double penalty” of tax on canceled debt.
Question: I had a rough patch in my life and succeeded in getting some credit card debt “written off.” I thought this meant I didn’t have to pay anything.
But now I got a letter from the IRS saying I have to pay income tax! On the forgiven debt! How is DEBT considered to be INCOME? If I had income, I wouldn’t be in debt! SMH!
This is ridiculous! Can you explain this to me? Is it even legit? Or am I being scammed? If it’s true, what can I do? I’m nearly broke as it is, and I was actually thinking about bankruptcy. Would that help?
– Moses in California
That is a great question, and I completely understand your frustration. I know it can seem almost like a cruel joke being played on you. But unfortunately this is not a scam. When credit card debt is forgiven, it’s rarely a simple process. Here’s a quick video primer…
Under IRS guidelines, canceled debt counts as taxable income. In ordinary circumstances, receiving a loan is not considered income, and paying it back is not a deduction. But when a lender cancels the debt, the IRS treats the amount of canceled debt as if it is indeed taxable income.
This is one of the harshest provisions in the tax code because it punishes folks who are already struggling. But there may be help! There are some instances when this “canceled debt income” can be excluded from income, and you can escape tax on it.
For example, if the canceled credit card debt was from a bankruptcy, or if you can prove to the IRS that you owed more total debt than the value of your assets (home, car, retirement accounts, etc.) at the time of the forgiveness, you may be able to avoid tax on the canceled debt income.
The IRS also has resolution programs specifically designed for those with financial difficulties — such as a payment plan, “Currently Not Collectible” hardship status, or a settlement if you qualify. If you would like more information, we have tax professionals on staff who can conduct an investigation into your tax situation and determine if you might qualify for some relief.
Question: I entered into a loan modification five years ago under HARP. The modification was not honored by my lender, and I had to sue. The result of the suit was my lender reduced the principal of my loan by $115,000, and they sent me a form called 1099-C. Do I really have to pay taxes on this?
– William in California
HARP stands for Home Affordable Refinance Program, and since it launched in 2009, it’s been the government’s most popular program for refinancing mortgages. Why? Because HARP is designed for homeowners who are “underwater” – meaning they owe more on their mortgages than their homes are worth.
There are a bunch of rules for qualifying – loan-to-value ratio must be 80 percent, etc. – but what’s important for William and other HARP participants to know is this: Yup, taxes can become an issue.
Like every other government program, complications abound. So I consulted two other financial experts who have sharp insights into William’s question.
“In many cases, when a lender cancels a portion — or all — of an outstanding balance, you usually have to consider that canceled debt as income and report it on your tax return for the year in which the debt was canceled,” says Crissinda Ponder, Staff Writer at LendingTree. “However, there are instances when the canceled debt can be excluded from your taxable income. One of those possible exclusions is a loan modification on your primary home. Since the principal balance on your mortgage has been reduced, you may qualify to exclude the $115,000 from your taxable income.”
So as you can see, the answer is: Yes, you must pay taxes – except when you don’t.
When you do, you need the tax form William mentioned. The IRS calls it a 1099-C. If the canceled debt is at least $600, you must fill one out. This form lists important information about the canceled debt, including the amount owed and the cancellation date.
For more on the 1099-C, I consulted Jacob Dayan. He’s the co-founder of Community Tax, one of the best tax consulting firms I’ve ever worked with.
Dayan says if the property is your principal residence, and the forgiven loan principal was part of an “arrangement entered into before January 1, 2018, or earlier,” you likely will not need to pay tax on the $115,000. But, he says… “If the home was not your principal residence, or the arrangement to forgive part of the loan principal was entered into in 2018 or 2019, then you likely owe income tax on the full $115,000. In general, there are no tax consequences for a loan. The borrower does not report the borrowed funds as income and does not report a deduction when the borrowed funds are paid back. However, when a loan is forgiven the tax consequences change and the amount of forgiven debt is taxable to the borrower.”
There’s a reason for all this back-and-forth. When the home mortgage crisis gripped the country starting in 2007, Congress enacted a provision to allow homeowners to exclude canceled debt as income (meaning no tax) as long as the canceled debt was for their principal residence.
But beginning in 2018, the government scaled back that provision significantly. For the tax years 2018 and beyond, Dayan says this: “To be excludable the discharged debt must, first, cover a mortgage on your principal residence and, second, the arrangement for the forgiven loan principal must be in writing and dated before January 1, 2018.”
He continues: “if the loan covered your principal residence and the agreement to forgive the principal occurred before January 1, 2018, you will be able to exclude the $115,000 on the 1099-C and pay no tax. But if this was a rental property or second home, and the agreement to forgive the loan principal happened on January 1, 2018, or after, you will be stuck paying tax on the full $115,000.”
If it confuses and confounds you, then my expert advice is this: Consult a tax expert like Jacob Dayan. In almost every case, you’ll save significantly more on your taxes than you’ll pay for the expert advice. As you can see, tax questions can easily get complicated. It often requires an expert to unspool the details – and find you the savings.