Ask Stacy: Do I Have to Pay Taxes on Forgiven Debt?

Photo (cc) by Suzie T

Your house is foreclosed. Your car is repossessed. Your credit card balance is written off.

If you think these events hurt your credit, you’re right. But they can do more than that – they can create a giant tax bill as well.

Here’s a question I recently received from a reader…

Dear Stacy,
I’m a long-time reader, but this is the first time I’ve written. I hope you can answer this question.
Like lots of people, I lost my home to foreclosure. I was recently talking to a friend of mine, and they said that even though the bank took my house back, I might have to pay taxes too. Is this true?
– Fred S.

Here’s your answer, Fred!

Unpaid debts can lead to taxable income

While borrowed money isn’t regarded by Uncle Sam as income, if you don’t pay it all back, the unpaid balance is.

Example: I loan you $10,000 and you only pay back $5,000. The day I give up trying to collect and write off the $5,000, as far as the IRS is concerned, you made $5,000. It’s the same as if you’d won $5,000 in a contest, or at a casino. In short, you’re $5,000 richer, and Uncle Sam wants his cut.

If you owe $10,000 on a credit card debt, negotiate with the credit card company and end up settling it for $5,000, same thing.

If you owe $100,000 on a mortgage, give the house back in a foreclosure and it only sells for $50,000, the bank takes a $50,000 loss. As far as the IRS is concerned, that’s $50,000 you earned.

So whenever you pay back less than you borrow, if the forgiven debt exceeds $600, you’re likely to get a 1099-C form in the mail the following January.

If you find yourself facing this misery, at least you’ll have plenty of company. According to this USA Today article, more than 6 million 1099-C’s were expected to be mailed in 2012 alone.

But don’t freak out yet: There are exceptions that may allow you to dodge this bullet.

When forgiven debt isn’t taxable

Fortunately for Fred and millions of other hapless homeowners, since 2007, forgiven foreclosure-related mortgage debt is rarely taxable.

The 2007 Mortgage Forgiveness Debt Relief Act, extended through the end of 2013, specifically excludes forgiven mortgage debt from income. At least, as long as it related to a primary residence, was less than $2 million for joint filers, and, as the IRS puts it, was “directly related to a decline in the home’s value or the taxpayer’s financial condition.”

So if the forgiven debt is home-related, you’re probably in the clear.

Here are some other situations where forgiven debt isn’t taxable:

  • If the debt was discharged in bankruptcy.
  • If the debt was forgiven when you were insolvent. This is the strategy used by many with canceled or settled credit card debts. You’re insolvent when what you owe exceeds what you own; in other words, your debts exceed your assets. This doesn’t mean, however, you don’t report it. The forgiveness is non-taxable only to the extent of your insolvency, and you’ll have to fill out a worksheet and file an IRS form.
  • Non-recourse loans. When the lender’s only recourse is to repossess the financed property, that’s a non-recourse loan. In other words, the lender can’t come after you personally. While some real estate fits this bill, car loans almost never do.
  • Some student loans can be canceled in exchange for entering certain professions or performing public service. If they meet the criteria, cancelation of these debts is non-taxable.

Note that qualifying to have your forgiven loan rendered non-taxable doesn’t make it automatic. If you get a 1099-C, so did the IRS. So if you’re entitled to an exemption, you’ll have to file a Form 982 with your tax return and prove your position.

The bottom line

The numbers involved in forgiven debt can be big, and so can the tax bill. While you can check out examples and read about it in this IRS booklet, if you get a 1099-C or otherwise think you may have to deal with forgiven debt, I’d advise enlisting the services of a tax pro. This is complicated stuff, and not an area where you want to get it wrong.

Got a money-related question you’d like answered?

Drop me a line! Just try to make sure your question would be of interest to our other readers – don’t ask for personal or super-specific advice. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

Got more money questions? Browse lots more Ask Stacy answers here.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

Read Next
7 Free Tools for Saving More Money at Amazon
7 Free Tools for Saving More Money at Amazon

Use these websites and other tools to save money — or earn extra cash — when shopping at Amazon.

12 Ways to Maximize Your Social Security Checks
12 Ways to Maximize Your Social Security Checks

You may be eligible for more retirement income than you realize.

7 Things I Never Buy at Costco
7 Things I Never Buy at Costco

A bulk buy isn’t always the best buy.

7 Other Retailers With Free Prescription Delivery
7 Other Retailers With Free Prescription Delivery

Amazon’s new pharmacy is hardly the first to offer free shipping.

13 Affordable Products for a Better Night’s Rest
13 Affordable Products for a Better Night’s Rest

These Amazon products can help you finally catch 40 winks — or more.

View this page without ads

Help us produce more money-saving articles and videos by subscribing to a membership.

Get Started

Most Popular
7 Kirkland Signature Items to Avoid at Costco
7 Kirkland Signature Items to Avoid at Costco

Even if it seems you save a bundle buying Costco’s Kirkland Signature brand products, they may not be the bargain they appear to be.

How to Buy Gas At Costco Without a Membership
How to Buy Gas At Costco Without a Membership

The warehouse club often has some of the cheapest gas in town. Here’s how you can get it as a nonmember.

10 Things to Stop Buying If You Want a Clutter-Free Home
10 Things to Stop Buying If You Want a Clutter-Free Home

If you like to keep things simple, avoid these purchases.

Prices Are Soaring on These 7 Items
Prices Are Soaring on These 7 Items

Some surprise price jumps are making life more difficult for consumers.

A Simple Way to Silence Robocalls Today
A Simple Way to Silence Robocalls Today

A few steps can keep your phone from ringing when a spammer calls.

If You Find This Thrift Shopping, Buy It
If You Find This Thrift Shopping, Buy It

This iconic dinnerware is prized for everyday use as well as reselling for profit.

This Company Makes the Best Tires in America
This Company Makes the Best Tires in America

Driver satisfaction with tires is at an all-time high, but one brand stands out.

7 Home Improvements That Cost a Lot More in 2021
7 Home Improvements That Cost a Lot More in 2021

These projects will take a bigger bite out of your budget than in the recent past.

This Health Issue Can Hint at Dementia Years in Advance
This Health Issue Can Hint at Dementia Years in Advance

One type of pain is especially associated with cognitive decline.

Can I Switch to Spousal Social Security Benefits When My Ex Dies?
Can I Switch to Spousal Social Security Benefits When My Ex Dies?

Knowing when to claim can help you maximize benefits.

Medicare Will Not Cover These 6 Medical Costs
Medicare Will Not Cover These 6 Medical Costs

Don’t let these health care expenses catch you off guard in retirement.

8 Things You Should Always Buy on Amazon
8 Things You Should Always Buy on Amazon

The giant retailer shines when it comes to these things, from basics to hard-to-find specialty goods.

Beware This Hidden Ingredient in Rotisserie Chicken
Beware This Hidden Ingredient in Rotisserie Chicken

Something foul may lurk in those delicious, ready-to-eat birds.

5 Ways to Get Amazon Prime for Free
5 Ways to Get Amazon Prime for Free

Hesitant to drop $119 a year on an Amazon Prime membership? Here’s how to get it for free.

5 Ways to Fill Your Pantry With Free Food
5 Ways to Fill Your Pantry With Free Food

Anyone can take advantage of these resources.

5 States With the Worst Health Care for Retirees
5 States With the Worst Health Care for Retirees

All of these states are located in the same region of the nation.

7 Big Purchases You Should Never Make
7 Big Purchases You Should Never Make

Sometimes a big-ticket purchase is nothing more than a big waste of money.

Never Buy These 10 Things on Amazon
Never Buy These 10 Things on Amazon

Just because you can purchase something on Amazon doesn’t mean that you should.

3 Ways to Get Microsoft Office for Free
3 Ways to Get Microsoft Office for Free

With a little ingenuity, you can cut Office costs to zero.

View More Articles

View this page without ads

Help us produce more money-saving articles and videos by subscribing to a membership.

Get Started

Add a Comment

Our Policy: We welcome relevant and respectful comments in order to foster healthy and informative discussions. All other comments may be removed. Comments with links are automatically held for moderation.