Forgiven Debt Vs. Bad Debt
The terms bad debt and forgiven debt may refer to the same debt, but from different perspectives. Lenders may forgive a consumer’s bad debts when it is evident that the debts will not be repaid. Not all bad debt is forgiven; lenders may choose to sell the debt or continue collection attempts indefinitely. The terms settled debt or debt cancellation also refer to forgiven debt. The Internal Revenue Service stipulates the protocol for deducting bad debts or claiming forgiven debt as income.
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Bad Debt Definition
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According to the IRS, bad debt is an amount of money included as income, but is not collectible. Bad debts may be business- or non-business related. Business-related bad debts include credit sales to customers, loans to suppliers or clients and business loan guarantees. If the bad debt is non-business related, it must be totally worthless in order to qualify as a tax deduction. A debt becomes worthless when the facts and circumstances surrounding the debt indicate that there is not a reasonable expectation of payment, according to the IRS.
Forgiven Debt Definition
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When a lender declares a debt as not collectible and stops collection attempts or settles the debt, the debt is bad but also forgiven. Lenders dealing with unsecured credit card debts that are in default may write off the debt as bad and forgive the debt to the consumer. When a debt is forgiven, the lender agrees that it does not expect to collect the money owed and forgives the lender for the outstanding amount, or a portion of the outstanding amount.
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Bad Debt Tax Implications
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A business with bad debts deducts the amount of the bad debt from its gross income when calculating taxable income. Business bad debts may be fully or partially deducted using a charge-off or non-accrual experience accounting method. Non-business bad debts must be reported on Part 1 of the IRS Form 1040, Schedule D as a short-term capital loss. Taxpayers claiming a non-business bad debt must also submit a separate, detailed statement about the debt with their tax return.
Forgiven Debt Tax Implications
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Most forgiven debt in excess of $600 is considered income by the IRS. Lenders who forgive debts in excess of $600 typically send a 1099-C to the account holders and to the IRS. The IRS considers forgiven debt as unearned income. The Mortgage Foreclosure Forgiveness Act allows taxpayers to exclude up to two million dollars of income during the calendar years 2007 through 2012. This means that foreclosed homeowners need not count the forgiven amount of the mortgage debt after a foreclosure as income, as long as it does not exceed two million dollars.
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