IRS Rules About Debt Reduction

The IRS gives tax breaks to only some debt reductions.

Debt forgiveness and cancellations can be useful when dealing with financial hardships. In these situations, you might assume the Internal Revenue Service wouldn't count a debt reduction as taxable income. The IRS used to count most forgiven debt as taxable, but when financial troubles compounded in America in the 2000s, the IRS relented on one particular matter of debt. For all other debts, tax exclusions ultimately depend on your financial situation.

Mortgage Debt Relief Act

In 2007, the IRS created the Mortgage Debt Relief Act that can be applicable from the time of its creation up to 2012. Up to $2 million in mortgage debt can be forgiven for a single person under the act. If you’re married, then you can only be forgiven up to $1 million per individual. To take advantage of this, the debt has to apply to a declining value in your home or your inability to pay your mortgage due to your finances. It also has to apply to an attempt to reduce debt by refinancing your mortgage. Should you have a foreclosure on your home, this act will give you a chance to relieve the debt without counting it as income. Any other situations beyond the above won’t apply to debt forgiveness. During tax season, report your debt cancellation on the IRS’s 982 form, known as Discharge of Indebtedness.

Debt Cancellations

If you borrow money from a commercial lender and the lender cancels a debt you can’t pay, the IRS will count that as taxable income. The commercial lender who forgives your debt must report it by filling out a 1099-C form, Cancellation of Debt, and sending it to you.

Bankruptcy

Once a bankruptcy procedure is completed, you don't have to worry about the canceled debt being taxable income. This applies to debts of any amount, even though the true penalty is a blemish on your credit record.

Exclusion of taxable income on a canceled credit card debt isn’t always possible. However, if a debt was canceled during a Chapter 11 bankruptcy case for a corporation, the IRS will waive it off as non-income.

Insolvency

When a lender cancels your debt while it is equal with the value of your assets, the canceled debt won’t count as taxable income. This is the only exception to a loan obtained through a commercial lender. Those who are insolvent after a debt cancellation would possibly file for bankruptcy.

Farm Debts

The IRS allows farmers some breaks when it comes to debt cancellations. These breaks are allowable if your debt is all from farming expenses. Additionally, if half of your income from the last three years was due to farming, the IRS will allow canceled debts to be tax-free.

Student Loans

It’s possible to have a canceled student loan excluded as taxable income, though only under certain circumstances. If you made an agreement with the lender that you would work in a certain job for a length of time, the IRS considers that another obligation in place of paying the loan. Additionally, you can exclude taxable income off a student loan if the loan was made through a government organization, a tax-exempt corporation or a school that has work programs placing students in occupations with employee shortages.

References

• IRS: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation

Resources

• IRS: 982 Form (PDF)
• IRS: 1099-C Form (PDF)