Ask Stacy: Why Did I Get a Tax Bill for Forgiven Debt?

To err may be human, but to forgive isn’t always divine.

Turns out that when you have a forgiven debt — say, one written off by a student loan lender or credit card company — you’re likely to get a surprise: a big, fat tax bill.

Here’s this week’s question:

My student loans were discharged in 2014 because I became totally disabled. I received a 1099-C for over $60,000. Do I have to claim this as income?
– JoAnn

The short answer? Yes, but it may not be as bad as it looks.

Forgiven debt: how it works

In general, if you owe money and it’s written off as uncollectible, as far as Uncle Sam is concerned, the destroyed debt is taxed like income. Using JoAnn as an example, because she’s no longer on the hook for $60,000 of her student loan debt, she got a 1099-C at the end of the year for $60,000, which will be reported to the IRS as taxable income.

In JoAnn’s case, this seems to border on the insane. If she’s disabled to the extent that she can’t repay her student loans, how is she supposed to pay a huge tax bill? After all, it’s not like she has the $60,000 sitting in the bank: She presumably already spent that money on her education. So why bother twisting the knife with a tax bill she can’t pay?

To understand the logic, imagine another scenario, one in which forgiven loans aren’t taxable: MoneyTalksNews lends me $60,000. After a couple of months, it forgives the debt. Result? I just received $60,000 in tax-free income, and MoneyTalksNews just got a $60,000 tax deduction for an uncollectible debt. I win, MoneyTalksNews wins, Uncle Sam loses.

That’s why forgiven debt is normally taxable. Bad debts are deductible to the one losing the money and income to the one who doesn’t have to pay it back. 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, JoAnn will file Form 982. This is generally the form people file when they enter into debt forgiveness agreements like JoAnn’s, and it will probably be her best chance at avoiding paying taxes on her forgiven debt.

Exception: bankruptcy

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

Exception: mortgage debt

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

Because that results in forgiven debt, many homeowners who lose their home receive mail months later informing them they owe taxes on potentially hundreds of thousands of dollars of money 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 that reduces the principal on their mortgage.

Sometimes Congress rides to the rescue. For example, after the housing market cratered and foreclosures were running rampant, they passed the Mortgage Forgiveness Debt Relief Act of 2007. This law allowed tax-free forgiveness for certain types of forgiven mortgage debt during tax years 2007 through 2014.

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 nonbusiness 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 article 10 Things Worth Paying More For, which included, in certain cases, experienced professionals.

Because of the detail (Publication 4681 is 26 pages long) and the amount of money involved, this is a situation that calls for expertise. JoAnn should visit a local tax pro. In an ideal scenario, she would have done it before the debt was forgiven, but better late than never.

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About me

I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.

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