Even When Debts Are Forgiven, the Tax Man Still Cometh

The closer we get to this year's tax deadline, the more that the utterance of the phrase "IRS" feels like a curse word. This feeling often comes with good reason, for example as a general principle, the Internal Revenue Service (IRS) will treat forgiven or cancelled debts the same way it treats income - the IRS taxes it. The idea is that money borrowed from a lender was not taxed because there was an obligation to repay it. However, once the obligation to repay is removed through cancellation or forgiveness, the gain is treated like income and the IRS wants to tax it.

Cancelled debt includes money a lender is unable to collect from a borrower and that is eventually "written off" by the lender. It could be a credit card bill or an auto loan. Whatever its form, it is money the borrower is unable or unwilling to pay and the lender essentially gives up trying to collect. Even if the failure to repay was due to financial inability, the IRS will still treat the cancellation or forgiveness as income.

Bankruptcy

One exception to this general principle is bankruptcy. Debts discharged through bankruptcy are not considered income for tax purposes. Through bankruptcy, credit card debt, auto loans and most other forms of debt are dischargeable. However, federal law generally prohibits the discharge of past tax liability, spousal or child support, debts from malicious damage to people or property, student loan debt and fines or penalties owed to a government agency.

Mortgage Debt

Another exception to the general principle is forgiven, cancelled or discharged mortgage debt, which is usually from a mortgage modification or foreclosure. The 2007 Mortgage Forgiveness Debt Relief Act specifically excludes from one's income cancelled debt that was used to buy, build or substantially improve one's primary residence. Forgiven or cancelled debt from secondary homes, business properties, automobiles and credit cards is not eligible for tax exclusion under the Act.

The Act applies to mortgage debt cancelled between 2007 and 2012 - up to $2 million in "qualified principle residence indebtedness" ($1 million for a married person filing separately). Debt from refinancing original, qualifying debt is also included, but the Act requires that the debt be secured by the home. Borrowers will receive a Form 1099-C from their lender and should submit a Form 982 with their annual income tax filing.

It should be noted, however, that the Mortgage Forgiveness Debt Relief Act is currently set to expire in 2012, and if that happens, forgiven mortgage debt may again be considered income by the IRS.

As tax season nears, it is important to remember that cancelled or forgiven debt is still subject to income tax. Two exceptions include discharged debt through bankruptcy and cancelled mortgage debt. But, the tax implications are quite complex and can vary dramatically with even minor differences in circumstances, so contact an experienced bankruptcy attorney to discuss your situation and options.