Anyone that has succeeded in having their debt forgiven or discharged needs to report it as income on the tax return. This article discusses all a taxpayer has to expect to avoid surprises.
Explaining What Cancellation of Debt is
Debt cancellation is when a lender does not collect all or part of the debt someone owes. This does not affect the credit score, except the cancellation happens via bankruptcy. Debt cancellation will typically occur in correspondence to a debt forgiveness program.
The department of Education in America, for instance, gives income driven repayment plans to students owing federal loans. People with these plans have as much as 20 or 25 years. After such a period, any debt left will be forgiven.
Debt cancellation removes you from the hook for the amount owed. This means that the lender cannot come after you for the funds.
Effect of Cancelled Debt on Taxes
If you have any debt forgiven, Uncle Sam considers them as income for the purpose of tax. For canceled debt above 600 USD, which is deemed taxable, you should get a form 1099C from the lender. It contains the canceled debt that one will report.
For debts forgiven below $600, one will still get a 1099C even though you will file your tax return.
You could have a huge tax bill, which is a factor of your current tax situation and the amount canceled. As a result, people who recently took advantage of a debt forgiveness program need to know the tax implications.
Will all Cancelled Debt be Taxable?
While you will generally have to pay taxes on all canceled debts, there are some exceptions to this. Here are various categories that exempt your forgiven debt from tax. However, one must report the debt even though it will not count as an income.
Bankruptcy: debts discharged via bankruptcy are not considered taxable. This is because your financial situation is critical already, and taxes are deemed to be unfair.
Insolvency: for people broke at the cancellation period; you have liabilities in excess of assets. This gives the opportunity to remove some or all of your canceled debt from the return. Your financial insolvency determines how much you can exclude.
Gifts: For the money, you borrowed as a gift from a friend or family member, not collected in full, can be classified as a gift for tax purposes.
Tax Deductible Interest: for people with canceled interest or mortgage loan, which was tax-deductible, there is no need to report the portion of interest value of the forgiven as your income. However, one needs to report the principal amount.
Some Student Loans: for people that have had their student loan forgiven due to service in a given field for a specified period, the forgiven amount is not taxable. This also applies to people that have their student loans discharged as a result of death or disability.
Debt Settlement and Cancelled Debt: What is the Difference?
There is a difference between having a forgiven debt and servicing debt for a lesser value compared to the amount owed. Debt forgiveness generally happens as part of a definite program. Debt settlement, on the other hand, is when you cannot pay the amount owed.
Debt settlement applies majorly to unsecured debts like personal loans and credit cards. With a debt settlement, your credit might have taken a hit, and setting can leave your credit worse off.
On the other hand, debt cancellation does not affect your credit score negatively. However, you will have to record the debt in both cases as income in the tax return.
Be prepared if the Debt is Taxable.
It is essential to arm yourself with the right tax information if you have used a debt forgiveness program. Consult a tax professional to know if you merit a tax exception. You need not do anything else if you do.
If you do not, the sooner you start preparing for the tax, the better. A tax professional can come in handy in helping you in making adequate preparations for the tax.
Make sure to work on a payment plan if you owe the IRS. You, however, can take advantage of IRS installment payment plans. There might be possibilities of interest and penalties till the payment are completed.
FOR MORE INFORMATION OR TO MAKE AN APPOINTMENT TO SEE HOW WE CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CONTACT Daniel P Vigilante, CPA & Profit Consultants BY CLICKING THE BLUE TAB ON THIS PAGE.
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