Ask Stacy: If I Settle a Debt, Do I Have to Pay Taxes?

If you’ve been watching the headlines lately, you may have seen an article about Bank of America offering to slash mortgage balances by an average of $160,000 for qualifying borrowers. Wouldn’t it be nice to have your mortgage reduced by $160,000?

Well, yes and no. Having a debt forgiven isn’t all wine and roses. Check out this recent email…

Dear Stacy:

I have been a longtime follower. I came across this article - If I Settle a Debt, Do I Have to Pay Taxes? - and have a quick question to ask you.

I owe $30K in medical expenses (a hospital bill) and right now it’s in the hand of a collection agency. It’s not on my credit bureau reports yet. However, I’ve made an offer to the debt collector of $7K as a payment in full, and the debt collector has accepted the offer. My question is, will the amount that’s forgiven ($23K) be considered taxable income since I am dealing with a collection agency in this case?

Your prompt response would be greatly appreciated. Thank you for your time.

- Mike

Here’s your answer, Mike!

Forgiven debt: how it works

In general, if you owe money and it’s eventually written off, as far as Uncle Sam is concerned, the destroyed debt is taxed like income. Using Mike’s example, since he’s no longer on the hook for $23,000 of his $30,000 medical bill, he’ll be getting a 1099-C at the end of the year for $23,000.

This might not seem fair. After all, it’s not like Mike got a check for $23,000. The forgiven debt is more like a gift, and gifts aren’t taxable. So why would the IRS treat this forgiven debt as income?

The logic lies in the way income and losses are treated for tax purposes. Basically, it’s yin and yang: One man’s deduction is the other man’s income.

When it comes to business, most transactions involving money are deductible to the one paying it and income to the one receiving it.

For example, if a bank pays interest on your savings account, they get to deduct that money as an expense on their taxes – and you count it as income on yours. And if the bank lends money you don’t pay back, the bank deducts the bad debt as an expense – and you have to include it in your income.

In short, the term “debt forgiveness” makes it seem like a gift, but it’s more like “debt deduction.” When one party is writing something off, the opposing party is typically reporting it as income.

That’s the rule and the logic behind it. But as with many rules, especially those relating to income taxes, there are many exceptions. Let’s look at a few.

Exception: insolvency

According to IRS publication 4681, if you’re “insolvent,” meaning you owe more than you own, forgiven debt isn’t counted as income. Their words…

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV (Fair Market Value) of all of your assets immediately before the cancellation.

To qualify for this exclusion, you file Form 982. This is generally the form people file when they enter into debt settlement agreements like Mike’s and will probably be his best chance at avoiding paying taxes on his forgiven debt.

Exception: bankruptcy

Debt cancelled through a Chapter 7 or Chapter 13 bankruptcy typically isn’t taxable.

Exception: mortgage debt

A foreclosure often includes cancelled mortgage debt – the amount of the mortgage not recouped when the home is taken back and resold.

Since that results in forgiven debt, the result for many hapless homeowners is losing their home, then months later getting a tax form in the mail informing them they owe taxes on potentially hundreds of thousands of dollars of income they never received.

Depending on state laws, the same could be true for those doing a short-sale (selling their home for less than the mortgage balance) or participating in a program like the one from Bank of America mentioned above.

Talk about salt in the wound!

Fortunately Congress rode to the rescue years ago and passed a law called the Mortgage Forgiveness Debt Relief Act of 2007. This law applies to homeowners whose mortgage debt is “partly or entirely forgiven during tax years 2007 through 2012.”

You can read the details at this page of the IRS website, or by reading Publication 4681. But in general, if the forgiven mortgage debt was less than $2 million for married couples ($1 million for singles), was secured by a principal residence (as opposed to a rental property or vacation home), and was used to purchase or improve the home (as opposed to buying a car or paying off credit cards), it’s not reportable as income.

Bottom line: seek assistance

These are some common exceptions that could help you avoid taxes on forgiven debt, but they’re not the only ones. There are also different rules for businesses, as well as for debts that are recourse (those for which you’re personally liable) and non-recourse. State laws can also play a part, and so can other laws. For example, after hurricane Katrina, Congress passed a law allowing those in affected areas to exclude forgiven non-business debts from their income that year.

As you know if you’ve read past articles like Tax Pros: Are They a Waste of Money?, I’m not a fan of paying people to do things you can do yourself. But this is a situation better addressed by the recent article 10 Things Worth Paying More For. In that post we said experienced professionals could be worth paying for.

Because of the detail (Publication 4681 is 26 pages long) and the amount of money involved, this is a situation that calls for expertise. Mike should visit a local tax pro – preferably before he even agrees to settle the debt.

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