6 exceptions to paying tax on forgiven debt

By Sally?Herigstad

If you had debt forgiven, wiped out or negotiated down (by paying less than what you owed) last year, you may have breathed a sigh of relief. What you may not have been aware of, however, is that you are generally required to count that forgiven amount as income on your tax return.

Or are you? Before you write a check to the IRS -- one you probably can ill afford -- see if you qualify for one of these six exceptions to paying tax on forgiven debt:

Exception 1: Debts discharged in bankruptcy. If you filed for bankruptcy protection, do not report the canceled debt as income.

Example: John was successfully sued for $500,000. He subsequently filed for bankruptcy and had the $500,000 debt, among other debts, canceled. John does not pay tax on the canceled debt.

Exception 2: Mortgage debt forgiven due to foreclosure. Thanks to the Mortgage Forgiveness Debt Relief Act, which took effect in 2007, you probably do not have to pay tax on debt forgiven when you lost your home. The act had been set to expire after the 2012 tax year, but?was extended by a year in the "fiscal cliff" negotiations that concluded in the first days of 2013.??

Example: Joe and Emily lost their home when their adjustable rate mortgage reset at a higher rate, Joe lost his job, and the value of their home dropped by one-third. Joe and Emily owed $380,000 on their home, but after expenses, the bank only realized $300,000 from the sale. The bank reports $80,000 as canceled debt, which prior to the Mortgage Forgiveness Debt Relief Act would have been taxable income. Fortunately for Joe and Emily, the canceled mortgage debt is not considered taxable income.

For more details, see the U.S. Taxpayer Advocate Service's publication, "Cancellation of debt and home foreclosures."

Exception 3: Debts canceled when you were insolvent. This is the most sweeping exception, because debt is generally only canceled when debtors are "insolvent" -- IRS-speak for being broke. Take note, however, the exclusion applies only up to the amount by which you are insolvent.

Example: Trisha owed $30,000 in credit card debt, which she settled by paying $5,000. She received a Form 1099-C showing canceled debt income of $25,000 ($30,000 minus $5,000). She had no other debts. Her assets at the time were worth $10,000.

Canceled debt: $25,000
Total assets: $10,000
Insolvency amount: $15,000

Trisha reports $10,000 ($25,000 minus the $15,000 insolvency amount) as income on her tax return.

Exception 4: Student loans forgiven after you worked a period of time. If your student loans contain a loan forgiveness provision based on service in your field of work, do not include the canceled debt as income.

Example: After Natalie finished her medical residency, she worked in an underserved area as a physician, as she agreed to under a loan forgiveness program. She does not, therefore, have to pay tax on the canceled student loans.

Exception 5: Forgiven interest that would have been deductible, such as interest on business debt. You do not have to pay tax on the portion of the debt due to interest, if you could have deducted the interest if you had paid it. On the other hand, if you could not have deducted it -- for example, if it was interest on a personal credit card -- you must pay taxes on all the forgiven debt, including the interest.

Example 1: You receive a Form 1099-C for forgiven debt on your business credit card, which you used only for your sole proprietorship business. The total canceled debt in box 2 on the form is $5,000 and the interest portion in box 3 is $2,000. Unless you qualify for any of the other exceptions, report the debt not including interest, or $3,000 ($5,000 minus $2,000), as income on the Schedule C for your business.

Example 2: The facts are the same as in the previous example, except it's your personal department store card. The interest is not deductible when paid; therefore it does not qualify for the exception. Unless you qualify for any of the other exceptions, report $5,000 on Form 1040, line 21 (for 2010).

Exception 6: Cancellation of debt as a gift. If the cancellation of debt is a gift, it's not income. Generally, the IRS will believe you if you say it is a gift and it's between parties such as family members or friends. The IRS takes a dim view of taxpayers claiming that canceled debt from banks, employers or anyone else with whom you have a strictly working relationship are "gifts." Note: If more than $13,000 of debt is canceled in one year, the gift giver has to file a gift tax return (although they almost certainly will not owe a tax). That should not affect you as the recipient.

Example: Roxy borrowed $6,000 from her dad while she was unemployed. She wrote up a promissory note for the debt. Now Dad says she doesn't have to repay him after all. Roxy does not have to report the forgiven $6,000 debt as income. (She should, however, make sure the promissory note is marked as "paid.")

In addition, you may not have to pay tax on canceled debt if it was in connection with your farm, or if the debts were attached to business real estate and were forgiven when you owed more than the property was worth. See Cancellation of Debt in IRS Publication 225, Farmer's Tax Guide or Business Income in IRS Publication 334, Tax Guide for Small Businessfor more information.

If you received a 1099-C form and you qualify for one of these exceptions, you still have to tell the IRS that you don't have to include the forgiven debt as income and why. File Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your income tax form, and consider your old debt that much further behind you.

See related: 1099-C surprise: IRS tax follows canceled debt

Updated: January 10, 2013

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