IRS Debt Forgiveness Information
If you are able to negotiate the reduction or elimination of your outstanding debt, you may have to pay a price for your success. In most cases, the IRS considers the forgiveness or cancellation of debt to be income, meaning you must pay tax on the amount of the reduction. In certain circumstances such as bankruptcy or insolvency, you may be able to avoid paying tax on the eliminated debt.
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Debt Forgiveness and Cancellation
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Debts that are forgiven are generally considered taxable income by the IRS because you received money on which you never paid tax. Common examples of forgiven debt include negotiated settlements with credit card companies and the cancellation of loan balances after foreclosure. For example, if you owe a credit card company $25,000 and negotiate that balance down to $10,000, the $15,000 reduction becomes taxable income to you.
How to Report Forgiven Debts on Taxes
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If you are the beneficiary of a forgiven debt, your creditor will issue you a Form 1099-C at the end of the year showing the amount of the cancelled debt. You must take this amount and transfer it to the "other income" section of your Form 1040 when you file your taxes, which you can find on line 21. The amount of your forgiven debt becomes a part of your total income and ultimately your taxable income.
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Bankruptcy
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Bankruptcy is one of the exceptions to the taxation of canceled debts. The discharge in bankruptcy removes a debtor's obligation to pay tax on the amount of the discharged debt. Most creditors discharged in bankruptcy will not issue a Form 1099-C, but if they do, they are obligated to check the box marked "bankruptcy" on the form.
Insolvency
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If the amount of your debts exceeds the amount of your assets, you are considered insolvent for IRS purposes. Under law, you do not have to pay tax on forgiven debt to the extent that you are insolvent. For example, if you have $100,000 in debt and $10,000 in assets, you are insolvent to the extent of $90,000. If you later negotiate that debt down to $50,000, you will not have to pay tax on that amount because your insolvency exceeds the amount of your forgiven debt. If you are issued a 1099-C in this situation, you can file Form 982 to exclude the amount of forgiven debt from your taxable income.
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