What You Need to Know About Canceled Debt and Taxes

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Imagine having years of punishing credit card debt canceled and gaining the clean slate you've always wanted. Then, out of nowhere, you receive a form in the mail that says you actually owe money for having that debt wiped away.

That situation happens all the time to consumers who have had part or all of a debt forgiven. The reality is, canceled debt may help you regain control of your finances, but the IRS still wants its share of what it sees as income you received. (See also: 12 Things You Should Know About the New Tax Law)

How debt is canceled

To understand the tax ramifications of canceled debt, it helps to know how this phenomenon works in the first place. How does someone get their debt canceled?

According to Steven J. Weil, president of RMS Accounting in Fort Lauderdale, Florida, debt can be forgiven on credit card balances, mortgages, auto loans, or nearly any other type of loan. This debt can become canceled in a variety of ways. One way is when consumers use a debt settlement company to negotiate a payment of less than they owe. (See also: 4 Ways to Negotiate Credit Card Debt)

Another example is when consumers who owe more than their homes are worth get their mortgage company to forgive the remaining balance during what is called a "short sale." A short sale is when the net proceeds from selling the property fall short of the debts secured by liens against the property. All the lien holders must agree to accept less than the amount owed on the debt in order for a short sale to go through.

Forgiven debt doesn't just go away, says Weil. "Whether it's consumer debt, auto debt, or any other type of debt, it becomes income to the consumer when they don't pay off their debt. The government rectifies this situation by charging taxes on forgiven amounts."

Unfortunately, consumers don't always know they are required to pay income taxes on forgiven debt. So, imagine their surprise when they receive a 1099-C in the mail that could lead to a larger tax bill.

What the tax law says

Creditors and debt collectors that accept at least $600 less than the amount you owe them are required by law to file 1099-C forms and send consumers a copy to use when they file their taxes.

As Weil notes, the form should clearly list the amount of debt you had forgiven — not the amount of debt you once owed.

Weil uses the following example to explain how forgiven debt is figured. Imagine you ran up your Visa card with a $10,000 balance (including principal, interest, and late fees) and cannot keep up with the monthly payments. After the debt is sent to collections, you work with a debt settlement company to reach a settlement that says you'll pay $3,000 to have the entire debt forgiven. In this case, the $7,000 in forgiven debt would end up on the 1099-C, says Weil. This form is then sent by the creditor that accepted the settlement to the consumer.

At least that's the way it should work. In some cases, consumers don't receive the 1099-C for whatever reason. But not receiving the form doesn't remove your liability, says Weil.

When your debt is forgiven, it becomes income to you — even if the creditor you work with fails to send a 1099-C. "If you don't get the form, you need to call the creditor and ask for it," says Weil.

Weil also says that, when somebody tells you they will forgive your debt, you need to get documentation of the event in writing. An official letter from the creditor acknowledging your forgiven debt amount will suffice when you're filing your taxes in the absence of a 1099-C, he says. Further, getting the agreement in writing will also protect you down the line if the details of your forgiven debt get jumbled somehow between your creditor and the IRS. (See also: What Happens If You Don't Pay Your Taxes)

Exceptions to the rule

Weil notes that the IRS offers several exceptions that let consumers in certain financial situations avoid paying taxes on forgiven debts. Those exceptions include insolvency. If after your debt is forgiven you have no cash or assets to sell to pay taxes on your debt, you won't have to pay income taxes.

But note that the exclusion applies only to the amount by which you were insolvent. So if you had $10,000 of credit card debts canceled at a time when you had $2,000 in assets, the insolvency amount is $8,000. You'll report $2,000 ($10,000 minus the $8,000 insolvency amount) as income on your tax return.

Also, if debt forgiveness makes you solvent, then it's taxable, notes Weil.

Other exceptions that let you avoid paying taxes include debt discharged in bankruptcy, debt given as a gift by a friend or family member, and certain business real estate and farm exclusions, he says.

If you're curious whether you'll qualify for an exclusion, Weil says it's best to speak with a tax professional who can look at the details of your unique tax situation.

When consumers aren't informed

If you're a consumer who has been hit with this surprise tax in the past, you may be wondering why you weren't informed of your tax liability. According to Weil, it's up to consumers to educate themselves on the best ways to handle their debts, including forgiven debt. Ideally, the different companies we work with will warn us about taxes we might owe, but you should never count on it.

Weil says debt settlement companies in particular should really be doing their part to educate consumers on their tax liability. These companies, which may be for-profit or nonprofit, usually tell consumers to stop paying their bills and save money for debt settlement in a joint escrow account instead. This way, when (or if) the debt settlement company strikes a deal to settle your debts, you'll have the cash on hand to pay the agreed-upon settlement amount.

Considering the fact that debt settlement companies can charge high fees and are supposed to be on the side of consumers, one would think these companies would lay out all the details for those they help. But they don't always.

"There's a lot of nondisclosure," says Weil. Because of this, "consumers should be very careful of debt consolidation and settlement agencies, particularly those that are for-profit."

The bottom line: You may owe taxes on forgiven debts, and you may receive a 1099-C in the mail from your creditor. If you don't receive the form, the onus is on you to figure out your tax liability.

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