Tax Consequences of Debt Forgivness
A common question I receive is how debt forgiveness will effect taxes. Debt forgiveness can happen in several different circumstances. For example, you can have a debt completely wiped clear from your creditor, or what is more likely to happen is that you settle the debt with the creditor for less then the amount owed. Another more common occurrence is when your principal residence is either foreclosed or is sold through a short sale.
This forgiveness of debt by the creditor triggers the so called cancellation of debt and the IRS can consider this taxable income. Once the debt is cancelled the lender is supposed to report to the IRS that the debt has been forgiven and will file a Form 1099-C.
Listed below are some exceptions to the rule
If the cancellation of debt occurs at the time the borrower is in bankruptcy there will be no tax consequences. It is important that any creditor has notice of the bankruptcy in order for them not to file a 1099-C form. This holds true for any Chapter 7, Chapter13 or Chapter 11 bankruptcy.
If the individual who receives the cancellation of debt is insolvent immediately before the cancellation of debt occurs, then the cancellation of debt is exempt from federal taxation. However there is a caveat to this, if the cancellation makes you solvent, the cancellation of debt is taxable.
3. Self Financed debt
If the cancellation of debt arose from a seller financed debt the cancellation will also be exempt.
4. Home Mortgage
Congress has enacted The Mortgage Debt Relief Act of 2007. Debt that is reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure qualifies for relief. The debt that is being forgiven only applies to a cancelled debt that was used to buy, build or substantially improve your prinicpal residence or to refinance debt incurred for those purposes. This also applies to short sales.
However the act is ending at the end of 2012. We have to wait and see what the legislature decides to do with and extension. For more information please see the below link:
5. Deductible interest
If the cancellation of debt includes unpaid interest that was added to your loan principal and then forgiven, the forgiven interest that you could have deducted is exempt from federal income taxation.
There is more specific information then the above rules and it is advised you contact an attorney or CPA before taking any action.