Do you have to pay tax for debt forgiveness?
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All of us look for lifesavers when we are drowning in a sea of debt sea. We look for something that would help us to stay afloat and reach the shore of financial safety. The lifesaver often arrives for rescue operations in the form of debt relief assistance and helps us to get on a stable financial boat.
Now debt relief assistance comes in the form of credit counseling, debt settlement, debt consolidation, or debt management. These programs help you to get out of debt while paying only a fraction of what you owe.
In debt settlement, you pay only a percentage of the total owed amount.
- You owe $2000 on a credit card.
- You owe $3000 on a payday loan.
- You owe $4000 on an unsecured personal loan.
Your total owed amount is $9000.
Debt negotiators negotiate with your creditors and lower your payoff amount like this:
- You have to pay $1000 on the credit card.
- You have to pay $1700 on the payday loan .
- You have to pay $2500 on the unsecured personal loan.
So in total, you’re paying $5200.
Your net savings – $3800.
It’s natural to feel happy and elated when you pay off debts and save money with debt relief assistance. You won’t have to make any more payments to creditors.
But… you still can’t have the last laugh of the day. Thanks to the IRS.
The IRS has a stern eye on your financial boat. They might want a share of your savings in the form of tax.
Why should you pay tax for forgiven debts?
In the example given above, you have borrowed $9000 in total. And, how much have you paid?
You have paid only $5200. The remaining amount is your income. At least, that’s how the IRS would like to see it.
You have borrowed and enjoyed $9000. But you have paid $3800 less than the total owed amount to creditors. It’s their loss actually. They should get tax deductions for it, and you should pay tax on it. At the end of the day, it’s your income.
For the IRS, the logic is simple. You have to pay tax on your income.
What is the role of the 1099-C form?
This form has a crucial role in your financial life. Whenever you’re saving more than $600 due to debt forgiveness, creditors would send you the 1099-C form. You have to report the amount mentioned on the 1099-C tax form as your income for the respective financial year and pay tax on it. If you don’t report the income to the IRS, then you would be at risk of getting heavily penalized. Don’t underestimate the power and the capability of the IRS. They notice everything.
When can you avoid paying tax on forgiven debts?
There are a few circumstances when you can avoid paying tax on forgiven debts. Here are a few of them.
(i) When your debts were forgiven in bankruptcy: Debts forgiven in bankruptcy are not taxable. The logic is simple. When you file Chapter 7 or Chapter 13 bankruptcy, your financial life is already in a state of topsy-turvy. The IRS is not so cold-hearted to slap you again with a tax bill on your face. That would be brutal.
Just because you don’t have to pay tax for the debts forgiven in bankruptcy, you shouldn’t go for it on the first chance. Being bankrupt is not a nice thing. Potential creditors would always consider you as a risky borrower. That would affect your chances of qualifying for a loan at favorable interest rates.
(ii) When your debts were forgiven due to insolvency: If your liabilities were more than your assets when debts were forgiven, and you can prove that to the IRS, then there is good news. The IRS won’t charge tax for the forgiven tax. There is no need to count it as your income.
If you want to avoid paying tax citing insolvency, then here are a few steps you need to take:
- Note down the total fair market value of your assets when your debts were discharged.
- Note down the total fair market value of your liabilities when your debts were discharged.
- Subtract the fair market value of your assets from your liabilities.
- If the result shows that your liabilities were more than your assets when your debts were forgiven, then it means that you were insolvent. In this case, you may not have to pay tax on the forgiven debt.
Student loans forgiven due to permanent disability or death are not considered as taxable income as per the Tax Cuts and Jobs Act. This special benefit is available until 2025. Apart from this, student loans forgiven through the Federal Public Service Loan Forgiveness program are also not subject to tax.
Always read the latest tax laws to know about the recent changes before filing your 2019 income tax returns.
Stacy B. Miller is a writer, blogger, and a content marketing enthusiast. Her blog vents out her opinions on debt, money and financial issues. Her articles have been published in various top-notch websites and she plans to write many more for her readers. You can connect with her on Facebook and Twitter.
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