Posted by Jim McClaflin, EA, NTPI Fellow

What To Expect With Cancelation Of Debt / Repossession

What To Expect With Cancelation Of Debt / Repossession

You might need to report the canceled amount as income on your tax return if you could get a debt write-off or forgiveness. You should know what to expect so you don't end up with a considerable tax collection.

What Is Debt Cancellation?

Debt cancellation occurs when a creditor waives or cancels some or all of the debt owed. The process usually does not affect your credit score except in bankruptcy, but it can be costly. Debt cancellation is generally done as part of a debt reduction program.

For example, the US Department of Education offers income-based repayment plans for federal student loan borrowers. If you join one of these plans, the repayment term will be 20 or 25 years, after which any remaining debt will be canceled.

Once you write off your debts, you are no longer tied to the canceled amount, and you don't have to worry about the creditor suing you in the future.

How Does Debt Cancellation Affect Taxes?

The IRS considers most forms of debt to be forgiven, settled debt, or canceled as income for tax purposes. If the total amount of your canceled debt exceeds $600 and is considered taxable, the creditor must send you a Form 1099-C, including the canceled amount you will need to report.

If your canceled debt is less than $600, you may not be able to get a 1099-C, but you will still need to report it on your tax return.

Depending on the amount of debt paid and your current tax situation, a canceled debt can lead to a considerable tax collection. So if you've recently benefited from a debt relief program, you'll want to know if you're subject to tax and how to prepare yourself so that you aren't caught off guard when it comes to paying taxes.

Are All Forgiven Or Canceled Debts Taxable?

Although most canceled debts are considered taxable, there are a few exceptions to the rule. If your circumstances come under one of these categories, you may need to report the debt, but it won't count towards your gross income.

  • Bankruptcy: If your debt was paid during bankruptcy, it is not considered taxable income. The idea is that you are already in financial pain, and asking for tax payments can complicate matters further.

  • Insolvency: If you are in financial bankruptcy at the time of liquidation (your debts exceed your assets), you can omit all or part of your debts written off from your income on your tax return. The IRS determines the amount you can enter based on the extent of your financial obligations.

  • Gifts: If you lend money from your family or a friend and decide not to charge you the total amount, this is considered a gift for tax purposes.

  • Tax-deductible interest: If you had a canceled commercial or mortgage loan on which the interest was considered tax-deductible, you would not have to report the interest portion of the amount paid as income. However, you will still have to report the canceled principal amount.

  • Certain student loans: If your student loans were canceled in exchange for employment in a particular field or career for a specified period, the amount paid is not considered taxable income. The same is true if your student loans have been canceled due to death or permanent disability.

  • Real estate or farm debt: If your debt was related to a farm or real estate and meets other IRS eligibility criteria, you may be eligible for a notable exclusion.

The Difference Between Canceled Debts And Debt Settlement

Canceling or forgiving debt is a little different than paying off less debt than you have. While debt cancellation usually takes place under a particular program, debt settlement usually occurs when you are having difficulty paying what you owe and are in arrears.

Additionally, debt settlement is generally only available for unsecured debt, including credit cards and personal loans. Your credit might be in bad shape in a debt settlement situation, and the settlement can affect you even more.

On the flip side, debt cancellation usually doesn't have a negative impact on your credit score. However, you may need to report the debt as income on your tax return in either case.

If it’s taxable, be prepared.

If you've benefited from a debt forgiveness program, the sooner you know the tax consequences, the better. Talk to an accountant to find out if you qualify for an exception. If you do, you won't have to do anything else.

However, if it doesn't, you may need to start preparing for tax collection. A tax expert can help you calculate the numbers based on how much you are currently withholding from wages and the deductions and credits you are entitled to.

If you go into debt for money, start working on a savings plan right away to make sure you can pay it back. Although the IRS offers installment plans for people who cannot pay before the due date, they charge interest and a penalty until full payment is made.

FOR MORE INFORMATION ON HOW JIM McCLAFLIN, EA, NTPI FELLOW CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.

THANKS FOR VISITING.

Jim McClaflin, EA, NTPI Fellow
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