Income Calculations for Debt Forgiveness
When you choose not to repay a financial obligation, your creditor will typically choose to write off the debt after a specified period of time. Once a creditor writes off a debt, the creditor no longer will attempt to actively collect the debt. The Internal Revenue Service classifies written off debt as a type of forgiven debt and in some circumstances, the IRS will require you to recognize this forgiven debt as income on your tax return.
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What is Cancellation of Debt?
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The IRS requires financial institutions to report forgiven debt to both the borrower and the IRS by issuing a Form 1099–C. One of the primary reasons that lenders choose to forgive is to realize a tax deduction for writing off the debt. The IRS allows the lender to write off this debt, and the forgiven debt becomes income for the debtor because you no longer have an obligation to pay the forgiven amount.
Mortgage Forgiveness Debt Relief Act
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In the case of forgiven debt resulting from a mortgage obligation, the Mortgage Forgiveness Debt Relief Act makes it possible to exclude forgiven mortgage debt in certain cases. However, to qualify for this exemption, the forgiven debt must result from a mortgage on your principal residence. Additionally, this act allows you to exclude forgiven debt from your income that results from mortgage restructuring or a foreclosure.
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Limitations of the Mortgage Forgiveness Debt Relief Act
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This act exempts only debt secured by the home. Under this act, you can qualify for a maximum exemption of $2 million if you are married and file a joint tax return or $1 million if you file an individual tax return. Additionally, this act only applies for mortgage debt forgiven between 2007 and the end of 2012.
Bankruptcy Exception
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If the forgiven debt results from a bankruptcy, federal bankruptcy laws may allow you to exclude the forgiven debt from your income. However, this exemption depends on what type of bankruptcy you file. After the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, filing for bankruptcy has become a more complicated process. Specifically, the new bankruptcy laws make it much harder to completely discharge your debts through a Chapter 7 bankruptcy. If you do not qualify for a Chapter 7 bankruptcy, only a portion of your debt is forgiven through the bankruptcy process limiting your ability to exempt forgiven debt through the bankruptcy process.
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