According to the most recent reports from the Federal Reserve, the median household debt in America has risen to $75,600. As shocking as this statistic is, it’s been a long time coming – consumer borrowing has increased by 1700% since 1971. With the rise in debt came the need for debt relief. There are several options available. However, depending on the option you choose, there may or may not be tax consequences. In some cases, when debt is forgiven or settled for a reduced amount, the IRS may consider the amount forgiven to be taxable “income.” Seems unfair, kind of like kicking you while you’re down. But there are exceptions.
At the end of the day, a debt relief program may still be a better solution than managing the debt on your own, even with the additional taxable income. For instance, if you’re liabilities far exceed your assets, you may be exempt from paying taxes on all of your forgiven debt. To be sure, it is important to speak with an attorney or tax specialist to determine how a particular debt relief program will affect your taxes.
Understanding the Internal Revenue Code
Whenever you take out a loan, you are not required to pay any taxes on the money you receive, because you are obligated to pay the money back. Consequently, when you have a loan forgiven, you are no longer obligated to pay the lender back, and you’ve essentially gotten the money for “free”. To avoid a potential windfall, the IRS has decided to tax certain loans when they are forgiven.
Internal Revenue Code § 61 (a)(12) states that any type of cancellation of debt is considered taxable income. Cancellation of debt (COD) occurs whenever a creditor reduces the principal amount owed. Note that lowered interest rates, payment forbearances and payment extensions are generally not considered COD and thus do not carry with them the tax implications discussed in this article.
The COD that qualifies as income for taxing purposes may include:
- Short sales on real property
- Credit card debt settlement
- Negotiated pay-offs with third party debt collectors
*Note that in order to qualify the settlement must be for $600 or more.
Many forgiven debts do not qualify as COD income and thus are not subject to taxation. Exemptions include:
- Debts discharged in bankruptcy
- School loans forgiven because the borrower pursued a certain public interest occupation
- Certain farm loans
- Loans resulting from identity theft
- Insolvency (liabilities outweigh assets)
- Loans taken out to purchase, repair or build on the borrower’s principal residence – this exemption may or may not extend beyond December of 2012, depending on whether or not Congress extends the Mortgage Forgiveness Debt Relief Act (MFDRA)
The Insolvency Exception
For many who choose to enroll in a debt relief program, it’s because they owe far more than they could ever reasonably pay off, and more than the total assets they have. In other words, they’re insolvent. The good news is the IRS allows a taxpayer to exempt COD income to the extent the taxpayer is insolvent immediately before the cancellation. To illustrate what this means, let’s look at an example:
Example: Barbara has assets totaling $20,000. But her liabilities (credit card debts, etc.) are $60,000. With the help of a debt settlement attorney, she is able to settle her debts for $25,000 total. Her creditors may issue her a 1099-C for cancellation of debt income in the amount of $35,000 (the amount forgiven).
Immediately prior to the settlement, Barbara was insolvent because her liabilities exceeded her assets by $40,000. Barbara would likely be a candidate for the insolvency exception and not have to pay taxes on the forgiven debt.
This is good news for those who find themselves with significant debt, but assets that aren’t as significant. It means that it many cases, you can settle your debts for a fractional amount, and not have to pay taxes on the forgiven debt. That is a huge relief for borrowers. Of course, like any tax law, it depends on your particular facts and circumstances. To find out if debt settlement is right for you and whether you would have tax consequences, contact the attorneys at McCarthy Law for a free consultation.
This article, while educational in nature, is intended to provide only general legal information. For specific questions on debt settlement, bankruptcy or other debt relief programs and the related tax issues, you should always consult with a licensed attorney.