Once you reach a settlement agreement, there are key steps you need to tax if you want to avoid income tax liability on the canceled debt.
“I’m being taxed on what?!”
Most taxpayers know they pay income tax on their wages, or if they sell stock, or sell a house. However, many are unaware that IRS also levies income tax on canceled debts. The IRS treats canceled debt as taxable income, which increases your tax liability. Unless you take action, you could be paying taxes on the debt you didn’t pay back during your settlement.
Why is canceled debt taxable?
If a creditor decides to forgive an overdue credit card balance, if a vehicle is repossessed to partially satisfy a secured vehicle loan, or if a mortgage company forgives mortgage debt after a foreclosure, the taxpayer is on the hook for income tax for the amount forgiven. It’s essentially treated as if it were regular income, because it’s money you borrowed that you’re no longer obligated to pay back.
If you settle large amounts of debt, the tax bill can easily run to thousands or tens of thousands of dollars in additional tax. You could lose your refund or worse, you could end up owing the IRS and facing new challenges with tax debt.
Income tax on canceled debts often operates as a “double penalty.” Financial difficulties are typically the root cause of credit card debt, repossession and foreclosure. So, an extra tax bill on any forgiven debt adds a financial burden to someone already experiencing hardship. But there is some good news—IRS allows taxpayers to exclude canceled debt income (i.e. no extra tax due on canceled debt) under certain conditions.
How to qualify for an exclusion on debt canceled due to insolvency
IRS will exclude canceled debt if the discharge occurs for:
- a bankruptcy case
- qualified principal residence indebtedness
- insolvent taxpayers to the extent they are insolvent
- qualified farm indebtedness
- qualified real property business indebtedness
The two most common situations are when the taxpayer is insolvent and for qualified principal residence indebtedness. The IRS considers a taxpayer when their total liabilities exceed their total assets.
Filing an exclusion for the cancellation of debt due to insolvency
Applying for the insolvency exclusion involves filling out a form detailing all the taxpayer’s liabilities and assets (see IRS publication 4681). The IRS allows taxpayers to exclude canceled debt in an amount equal to how much their liabilities exceeded their assets.
For example, if a taxpayer has $10,000 in liabilities and $7,000 in assets, that taxpayer can exclude the difference; they qualify for forgiveness for up to $3,000 in canceled debt. The tax on $3,000 could up to almost $1,200. So, claiming this exclusion can make a big difference on the tax return’s bottom line.
Filing an exclusion for principal residence indebtedness
The second most common canceled debt exclusion is for qualified principal residence indebtedness. A qualified principal residence is your “primary home” that you live in most of the time. This type of cancellation most commonly happens when the lender agrees to a short sale or starts a foreclosure action.
Until 2016, IRS allowed an exclusion of up to $2,000,000 in canceled mortgage debt arising from foreclosure or short sales of taxpayers’ principal residences. This exclusion allowed the vast majority of taxpayers forced into foreclosure or short sales to escape the “double penalty” of a tax bill for any unpaid mortgage debt.
However, beginning in 2017 the IRS dialed back the exclusion. Now, the IRS now only allows the exclusion if the discharge was “subject to an arrangement that was entered into and evidence in writing before January 1, 2018” (See Instructions to form 982). So, while this provision has provided immeasurable relief over the past 10 years, it may not exist much longer.
It pays to work with a tax expert when it comes to canceled debt
People often think forgiveness on loans or credit card debts is the end of your troubles. You paid as agreed, so you can breathe easy. But once you’ve settled debt and it’s been discharged by the creditor, lender or collector, your work isn’t done.
The income tax levied on canceled debt can be a serious burden for taxpayers already in financial distress. You wouldn’t be settling debt and taking credit score damage if you had the means to pay. So, it’s critical to file your taxes correctly for any years where you settle a debt.
By knowing which types of canceled debt income you can exclude and by properly claiming it on your tax return, you can reduce or eliminate the “double penalty”. However, you must know how to file canceled debt on tax return forms to avoid liability.
The key is to have an experienced tax preparer on your side. You need someone to guide you through the process and ensure you are not overpaying. Without guidance, it is easy to fall prey to the “double penalty” of tax on canceled debt.
Debt.com’s trusted partners at Community Tax offer a free consultation and personalized tax investigation to determine if you qualify for an exclusion.Get Help Now
Contributors to this page include Jacob Dayan, co-founder of Community Tax, and Howard Dvorkin, CPA and founder Debt.com.
Article last modified on April 19, 2019. Published by Debt.com, LLC .