Forgiven Debt: How Settlements Increase Taxes

So you’ve just had a successful debt settlement. You had a large balance (let’s say something like $7,000), and now you have to pay just a portion of it ($4,000) within a couple of months. You might think the remaining $3,000 is gone for good, but think again. It’s called forgiven debt, and you might have to pay some of it to the government.

After you pay back the $4,000 to your creditor, the forgiven $3,000 part does not disappear. It gets noted by the government, and it gets taxed. That’s right; an amount of forgiven debt more than $600 less than the original balance is taxable income. It must be reported on Line 21 of your 1040 tax form as “other income.”

You probably thought once your balance was lowered and you paid the settled amount, business with the creditor was over. This is not entirely true, either. Again, if the forgiven debt is more than $600, you will have to report the amount on your tax form. Your creditor will also fill out a 1099-C form (“cancellation of debt”). The creditor will mail you a copy of the form, and you must send this in along with your 1040 form. If this form is not included, the IRS might charge you penalties, and not all will be forgiven.

There are possible exclusions from having the forgiven debt taxed. If you had declared bankruptcy or were insolvent before the debt settlement, the amount will be excluded from “taxable income.” If you are insolvent, this means your liabilities are greater than your assets, but you have not formally declared bankruptcy. If the $3,000 of forgiven debt exceeded your total assets by $1,000, the excluded amount applies only up to the point of insolvency. Therefore, you would still have to report $2,000 under “other income.” An amount of forgiven debt will also be excluded if it comes from farm indebtedness, real business property indebtedness, or a purchase price adjustment (in which the amount of a student loan was reduced after agreement by both buyer and seller). If any of these situations apply to you, you must also fill out IRS form 982, along with the 1040 form and the 1099-C.

Finally, if you have defaulted on a mortgage loan, the amount of forgiven debt might be excluded, according to the Mortgage Forgiveness Debt Relief Act. This would apply to money used to purchase, build, or repair your home, as well as a mortgage restructuring or foreclosure. You will also fill out form 982 in this situation.

Just because an amount of debt is forgiven does not mean it disappears. If you receive a 1099-C form in the mail, do not throw it away because this information has to be reported to the IRS, and you might be taxed on it.

David Pilley

David Pilley

David Pilley is a May 2010 graduate of the University of North Carolina at Chapel Hill, with a B.A. in communication studies and a creative writing minor. He is a native of Raleigh, North Carolina.

He played clarinet for the Marching Tar Heels in 2005 and 2006. He also volunteered for STV, the student-run television station at UNC-Chapel Hill, in the spring of 2010. He shot video, wrote scripts, and acted for “Off the Cuff,” UNC’s longest running sketch comedy show. He has the rare distinction of having lived in a dorm all four years of his undergraduate college career. He was also on Franklin Street on the night of April 4, 2009. His future plans are to pursue a master’s degree in journalism and to one day work for the media as a sports journalist or broadcaster.

Being one of eight children, David realizes finance is an important topic to everyone, regardless of his/her knowledge of the subject. His interests are in personal finance, budgeting, and savings.

In his spare time, David enjoys watching sports and standup comedy, as well as doing crossword puzzles and writing in the first person. He also thoroughly enjoys trivia and, one day, hopes to participate on the game show Jeopardy!, where he will try to break Ken Jennings’ 74-game win streak.
David Pilley

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