Taxes and Debt Forgiveness

As is often the case, our tax code is so complex that attempting to understand what you actually owe is not something that can be determined without professional assistance. I like to say that I would no more attempt to do my own taxes than I would attempt do-it-yourself open heart surgery. Abraham Lincoln had it right when he said, “He who represents himself has a fool for a client.”

As the stakes are raised so is the need for competent counsel from a CPA and/or an attorney.

Consider: When you or a third party acting on your behalf settles a credit card debt for less than the full amount owed, the IRS considers this a taxable event. In such cases you will receive a form 1099-C listing your forgiven debt as income. Just when you thought that you were through with your problems, you must list the amount found on the 1099-C on the “other income” line of your 1040, a nasty April surprise.

Or is it? With the IRS, one never really knows for sure.

Creditcards.com notes that there are six general exceptions.

1) If a debt has been discharged in bankruptcy, the forgiveness of that debt is not a taxable event.

2) Mortgage debt that is forgiven due to foreclosure is not taxable income, maybe. This exception is part of the 2007 Mortgage Forgiveness Debt Relief Act. It was set to expire in 2012. Congress extended this benefit through 2014. However, I don’t know if it was extended again in 2015.

3) Debts that were canceled when you were insolvent are not taxable income. What does that mean? Determining “insolvent” requires a calculation. Here is the example given by Creditcards.com:

“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”

4) If your student loans have been discharged by service in an approved Government program, the forgiveness of that debt is not taxable as income.

5) Interest that would have been tax deductible if it had been paid does not become taxable income after that debt is forgiven. Example: If you owed the interest on a business debt that could have been deducted as a legitimate business expense, you don’t have to pay taxes on that part of the debt when it is forgiven.

6) Finally, if a family member cancels your debt as a gift, the IRS will not tax that forgiven debt as income. If this involves parties who are not family members, this will not fly.

Don’t worry; it gets worse. The following information comes from Nolo.com, a legal advice website.

Most tax debt can’t be discharged in bankruptcy. In Chapter 7 bankruptcy, you will owe the taxman until the case is settled. In Chapter 13, you will have to repay in full.

These debts can only be forgiven in Chapter 7 bankruptcies in cases where a number of rather complex legal criteria have been met. I really consider this beyond the scope of a blog article or my understanding of the subject.

I am not terribly happy writing an article of this sort due to the inadequacy of my personal knowledge. While I always try to give credit to my sources, I am not sure that you should be taking legal advice from a website.

I once asked my CPA what seemed to me to be an innocuous question of the sort that must be frequently asked by her clients. In a very serious tone of voice, she told me she would need to do some research before she could answer my question. Nothing is simple which involves our tax code, but before you pay, make certain you are actually obligated.