Debt forgiven by a creditor. This could be taxed by the IRS!

Debt Forgiveness

If you have a debt forgiven by a creditor this could be considered income by the IRS and is taxable as if you had been paid the money. That means if you had a $10,000 credit card debt forgiven by a lender you will have to pay the IRS at least $1,000 in additional taxes. 

This is a bit of a kick in the backside for someone who is unable to pay the debt who then needs to find 10% or more of that amount forgiven to pay to the IRS. 

There are different ways forward and we will look at them here. 

How this works

A debt can be forgiven for a variety of reasons. The creditor may give up trying to collect the debt from you or decides it cannot collect the debt from you. 

You will often be sent a Form 1099-C – Cancellation of Debt. This informs the IRS of your tax liability for the debt that has been forgiven. It will detail the exact amount forgiven and the date from which it is forgiven. You should read this carefully and challenge, as necessary. The creditor should desist collecting the debt too. If they do continue to chase, they are breaking the law. 

You must also register this as ‘other income’ on your annual tax return.  

Where the pain really hits

If you are on a low income, then this ‘income’ could take you over the ceiling at which you qualify for things like Federal Earned Income Tax Credits. 

The ‘income’ could push you over the threshold for taxable income and you could find the forgiven debt taxed at a higher rate than you would normally pay. If you had a $10,000 credit card bill and you only earned $35,000 a year (paying 12% income tax) then $4,875 of that will be taxable at 22%, having crossed the threshold for the next tax band. 

Cases where the debt isn’t taxable

Nothing is simple with the IRS is it?! No black and white – just shades of gray. If everything were simple millions of tax professionals would be out of a job!

There is a long list of exceptions under current tax law where the forgiven tax is not taxable. These include:

  • If the debt is forgiven under a Title 11 bankruptcy
  • If the debt forgiven is as part of gifts, bequests, devises, or inheritances
  • If the debt was canceled under certain provisions of student loans
  • If the debt was a qualified business debt 

There are other exemptions that we will not discuss in detail here. 

Tax debt consequences

The irony of all this is that unless you can afford to repay the debt but are refusing you are likely unable to repay the debt as you simply cannot afford to make the repayments. Your credit rating will be trashed, and you will find it hard to get credit for up to six years after the debt has been canceled. 

Yet the government still wants your money? Almost without doubt you will end up in trouble with the IRS in this case, accruing tax debt that you did not exactly plan for. You will accrue penalty interest and charges and could be subject to punitive action from the IRS should you be unable to pay the debt. 

In such cases your best move will be to get in contact with us at Defense Tax Partners. Our team has many years of experience in dealing with the complex (and sometimes unfair) tax codes that often put those who are struggling into even worse financial problems than they were in before. 

We can negotiate with the IRS on your behalf and often reduce the amount of money you will have to pay them in the end. Why? Our job is to understand the tax system as well as they do and challenge their decisions. Over the years we have had many happy clients walk away with significantly reduced tax debt burdens. We look forward to hearing from you!

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