If you’ve been researching or talking to friends about debt relief options, you may have heard a horror story or two about people who thought they’d finally resolved their debts, only to get hit with a huge tax bill. The story typically goes something like this: 

John falls behind on his credit card debt and the issuer closes the account and sends him a demand for the full outstanding balance of $8,000–that’s just $33 more than the average credit card debt in Alabama. John doesn’t have the funds to pay off the balance and the creditor isn’t excited about taking small payments across several years. But, John has a large tax refund coming in just a few weeks. He negotiates with the creditor and they agree that he’ll pay $4,000 (50% of the balance) and the bank will write off the remainder of the balance. They get paid much sooner than they would otherwise, and John saves $4,000.

 

It seems like a win-win situation, and in many ways, it is. But, several months later, when John has all but forgotten about that particular debt and is juggling other bills, an envelope arrives. That envelope contains a 1099-C from the creditor, and it shows $4,000 in income. That’s $4,000 added to John’s taxable income for the year, with no withholding. Suddenly, this year’s tax refund isn’t looking so bright. 

Of course, the tax on the canceled debt is significantly less than the amount of debt canceled. So, John and others like him still come out ahead. The problem is that while he could have paid off that $8,000 debt over time, taxes are due on April 15. If the debtor’s withholding for the year wasn’t sufficient to cover regular income plus the canceled debt “income,” he or she may end up owing the IRS a significant amount of money. Worse, many people who receive 1099-Cs after settling debts had no idea they were coming, and are expecting to receive tax refunds. 

Understanding when canceled debt may result in a tax obligation and when it does not can help make good decisions about how to resolve debt and plan for the future.

When is Canceled Debt Taxable? 

The IRS considers most canceled debt taxable income. A creditor that forgives a debt or accepts partial payment in full settlement of a debt is required to issue a 1099-C in the amount canceled or forgiven, if that amount exceeds $600. But, that doesn’t mean that canceled debt in amounts less than $600 isn’t considered taxable income–just that the creditor isn’t required to issue a 1099-C. As with any other reportable income, you’re responsible for including it on your tax returns and paying tax on that “income” whether you’ve received tax documents from the payor or not.

However, there are some exceptions and some exclusions. Some examples of exceptions include forgiveness of debts as a gift or inheritance and student loan forgiveness associated with years of service in certain professions or underserved areas. 

There are also five listed situations in which canceled debt is excluded from gross income for federal tax purposes. The two of greatest interest to most people struggling financially are debt canceled when the debtor is insolvent and debt discharged under Title 11 of the U.S. Bankruptcy Code. 

Debt Canceled When the Debtor is Insolvent

It may seem that if you’re unable to pay your bills and at the point of creditors taking substantially reduced payments to cut their losses, you’re clearly insolvent. But, insolvent has a specific legal meaning. To be considered insolvent for purposes of excluding canceled debt from taxable income, your liabilities must exceed the fair market value of your assets. For IRS purposes, all of your assets are included, even if they serve as security for a loan or would be exempt from collection action. That includes the value of your home and retirement accounts. 

If your liabilities are greater than your assets, you’re insolvent for purposes of this test, but that doesn’t necessarily mean you can exclude the full amount of the canceled debt. This “income” is only excluded to the extent of your insolvency.

So, using our example above, if John’s liabilities were $10,000 greater than his assets, he’d be able to exclude the full $4,000 the creditor wrote off. But, if his liabilities were only $1,000 greater than his assets, he would only be able to exclude $1,000, and the remaining $3,000 would still be taxable income. 

In short, it takes a lot of calculation to determine whether or not you’re insolvent for purposes of excluding canceled debt from your taxable income, and you may not be able to exclude the full amount.

Debt Discharged in Bankruptcy

Debt discharged in bankruptcy is much simpler. The Internal Revenue Code says in part: 

Gross income does not include any amount which (but for this subsection) would be includable in gross income by reason of the discharge (in whole or part) of the indebtedness of the taxpayer if–

 

(A) the discharge occurs in a title 11 case…

Title 11 of the U.S. Code covers Chapter 7 and Chapter 13 bankruptcies, which are the two most common bankruptcies that consumers file.  Even though debts discharged in a bankruptcy are excluded as income for tax purposes, we often hear from our clients that they still received a 1099-C from one or two creditors whose debts were discharged in a bankruptcy.  Should a creditor issue a 1099-C for debt that was discharged in bankruptcy, the taxpayer simply needs to use Form 982 to exclude the amount from gross income for tax purposes.  

Talk to an Experienced Bankruptcy Lawyer before You Act

The possible taxability of canceled debt is just one of the many aspects of debt resolution that most people aren’t aware of when making decisions about their financial futures. The best way to avoid a costly mistake is to fully educate yourself about your options and the benefits and potential pitfalls of each. 

An experienced bankruptcy attorney can be the best source of that information. If you’re struggling financially in Mississippi, Alabama, or Tennessee, schedule a free consultation to learn more. 

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