Taxation on Credit Card Debt Forgiveness

The release from an obligation to repay debt often is seen as income by the IRS.

The Internal Revenue Service generally taxes all forms of income. While this is the general principal behind federal taxation, there are numerous exceptions to this rule. The Internal Revenue Service considers debt forgiveness to be a form of income; however, there are exceptions to this rule. Whether credit card debt forgiveness is considered taxable income depends on the circumstances of the situation.

Loan Tax Treatment

The Internal Revenue Service does not tax individuals as though they are receiving income when they receive a loan, because they have an obligation to repay that loan at a later date. Therefore, they are not actually earning any money in the long run. This is an important factor in the taxation of debt forgiveness. This applies not only to mortgages and car loans, but also the use of a credit card, which is a form of loan as well.

Loan Forgiveness

Because money received as a loan is not taxed as income due to the obligation to repay, once the obligation to repay has been eliminated, the justification for not treating a loan as income is also eliminated. Once there is no obligation to repay, the original loan is essentially a form of income. This is true for credit card debt as well. Even if the debt is reduced, but not entirely canceled, the taxpayer has to pay a tax on the amount of the reduction if it is greater than $600.

Bankruptcy

An exception to the general rule that debt forgiveness is taxable is bankruptcy. Debt forgiven during bankruptcy proceedings generally is not taxable. This makes practical sense, as a bankrupt taxpayer likely does not have the financial resources to pay a tax on forgiven debt, as he has already been forced into bankruptcy for failure to pay other obligations.

Insolvency

Another exception is in cases of insolvency. Insolvency refers to a situation in which an individual's liabilities exceed his assets. Unlike bankruptcy, an insolvency does not necessarily mean that an individual has filed for legal protection against creditors. The insolvency exception to debt forgiveness only applies to the extent that the individual is insolvent. For example, if an individual has $10,000 of credit card debt forgiven at a time when his liabilities exceed his assets by $4,000, the first $4,000 of the $10,000 of forgiven debt would not be taxed, while the remaining $6,000 would be taxed.

References

• Internal Revenue Service: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
• Smart Money: Tax-Wise, Debt Forgiveness isn't so Divine