Owing money is not fun, so when a creditor agrees to cancel a debt it may seem like a time for celebration. But before breaking out the cake, a little caution is in order. What borrowers see as debt forgiveness the government may well define as “imputed” income. And consider your canceled debt taxable.
When you throw taxes into the equation, it might be better to consolidate your debt with a personal loan instead of blowing it off.
When is canceled debt taxable income?
We usually think of “income” as the money we get from paychecks, selling assets, interest and dividends. But the government defines “income” differently. And to the IRS, canceled debt can also be income and possibly taxable.
Suppose you have $20,000 in credit card charges. And then you find the interest and payments are higher than you can afford. You can bet that creditors will want their money back. With interest. But sometimes, creditors do give up and write off the debt. They stop pursuing you and let it go.
Why might creditors give up their claims? There are two basic options. Think of them as war and peace.
War – why you may owe the IRS
In the first, case you battle your creditors. They have extracted as much money as possible through collection calls and legal actions. How hard they push for repayment depends a lot on how much you owe and how much they think you can pay.
Once they decide to stop pursuing you, creditors can write off your debt and sell the right to collect to a new creditor. Often for just pennies on the dollar. They write off your account balance at tax time. The reasoning is that what creditors get by selling your account and by deducting the loss is probably more than they’ll be able to squeeze out of you. So they hold their noses and write you off.
The debt buyer now owns the debt and the right to collect from you. How much did it pay for $20,000? Probably not a lot. In 2016 HBO’s John Oliver memorably purchased almost $15 million in medical debt for about $60,000. That works out to roughly $1 for $250 in debt or less than a penny on the dollar. Oliver then forgave the debt owed by nearly 9,000 patients.
The dreaded 1099-C
The debt buyer will try to settle with you. You owed $20,000. Would you pay $1,000? $500? Using the John Oliver example, the debt buyer may have paid just $80, so even a small repayment might look good ($20,000 divided by $250 = $80).
Let’s say the settlement cost to you is $1,000. You owed $20,000 but did not pay back $19,000. So far, so good. But then, around January 31st, you receive an IRS Form 1099-C from the debt buyer showing that you did indeed “earn” $19,000.
Maybe you’re in the 24% tax bracket. You now owe the IRS $4,560. Your state may also choose to tax the debt. In California, for example, that amount could be as high as 13.3% of the forgiven debt. In this case, that’s another $2,600.
Peace – how to avoid debt settlement tax payments
There are ways to cancel debt tax-free. These include:
- Debt included in bankruptcy
- Student loans forgiven in certain circumstances — for instance if you choose to teach or practice medicine in an underserved area
- Debt “gifted” to you tax-free (if, for example, you owe your parents, they can “gift” you up to $15,000 exempt from tax)
- Insolvency — that is, your debts exceed your assets. In this case, your debts must exceed the value of your assets by at least $20,000 in order to avoid taxes on all of the canceled debt
Mortgage debt forgiveness
One of the by-products of the mortgage meltdown was that millions of people found themselves with debts far larger than the fair market value of their homes. Many owners got rid of unaffordable a mortgage payments by completing a short sale. That means their mortgage lender agreed to accept the proceeds of the sale as complete repayment of the outstanding mortgage.
In other cases, the lender foreclosed, took back the property and sold it for (usually) less than the balance on the mortgage.
Under the rules in place at the time, unpaid mortgage debt was — you guessed it — taxable income. To provide relief to citizens battered by the recession and loss of their homes, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007.
Can you still get relief from the 2007 law and its extensions? Maybe. According to Nolo.com:
“On February 9, 2018, President Trump signed the Bipartisan Budget Act of 2018. One provision of the law extended the time period of the Mortgage Forgiveness Debt Relief Act to include indebtedness that is discharged before January 1, 2018, and to written discharge agreements executed before January 1, 2018.
“So, this exclusion applies to debt forgiven in calendar years through 2017, as well as debt discharged in 2018 if there was a written agreement entered into in 2017.”
Will mortgage debt forgiveness be extended? We don’t know. It’s happened before so keep your eyes on Capitol Hill.
Debts and taxes are complicated. Before writing a check for a debt you may not be required to repay or tax bills you may not owe, contact a qualified attorney, tax professional or legal clinic. It may be cheaper and smarter to refinance your debt to something more affordable and repay it over time.