Negotiating to decrease or zero out a credit card bill or other loan balance can help relieve a tough financial situation, but it can also give way to an unexpected tax bill. Here’s a quick review of various debt cancellation situations and how they impact you and your taxes.
- Consumer debt. If you have a credit card balance or loan forgiven, be prepared to receive IRS Form 1099-C representing the amount of debt cancelled. The IRS considers that amount taxable income to you, and they expect to see it reported on your tax return. However, if you’ve filed for bankruptcy or have liabilities that exceed your assets, then you may not need to report a cancelled debt as taxable income.
- Primary home. If your home is short sold or foreclosed and the lender receives less than the total amount of the outstanding loan, expect that amount of debt cancellation to be reported to you and the IRS. But special rules allow you to exclude up to $2 million in cancellation income in many circumstances. You’ll need to fill out paperwork to report this special homeowner exclusion to the IRS, but the end result can be a generous tax break for you and your family.
- Student loans. While this topic has generated plenty of recent headlines, the basics of student loan forgiveness have remained essentially the same. If your school closes while enrolled or soon after you withdraw, you may be eligible to discharge your federal student loan and not include the forgiven amount as taxable income. And if you are able to take advantage of the recent student loan forgiveness provision under the American Rescue Plan Act of 2021, your cancellation may be exempt from federal tax. The challenge, though, is that recent forgiveness programs are still being challenged in court AND your state may still wish to tax the loan forgiveness.
- Second home, rental property, investment property, & business property. The rules for debt cancellation on second homes, rental property, and investment or business property can be extremely complicated. Given your cost of these properties, your financial condition, and the amount of debt cancelled, it’s still possible to have this debt cancellation taxed at a preferred capital gains rate, or even considered not taxable at all.
Each of these themes have one thing in common – the tax laws can be complicated and you will probably need help navigating your situation.
