Did You Know You Might Owe Taxes On Debt That's Forgiven? Here’s How It Works.

Posted by Sheldon Lazarow | Nov 24, 2020 | 0 Comments

When you owe creditors money that you can't afford to repay, sometimes you may be able to get the debt forgiven or otherwise cancelled. When this happens, you no longer owe your creditors the money that you used to owe them.

The IRS, however, usually treats such canceled debt as income that you've received. Income that you could owe taxes on. If you fail to report it or fail to pay your taxes on the cancelled debt, you'll end up owing penalties and interest, and over time, that could be just as big of a hassle as your original debt.

Note: If you have any tax trouble or owe more than $10k to the IRS but can't pay in full, contact our firm today. We help people find tax relief and sometimes settle their tax debt for a fraction of what's owed.

When Do I Not Owe Taxes On Forgiven Debt?
In some cases, you may get an exemption and there are some circumstances in which you won't owe taxes.

Your debt is discharged through bankruptcy proceedings:
If you are in serious financial trouble, you may file for bankruptcy and have your debts discharged by the court. Such debts, while they are forgiven, are not considered taxable.

You're insolvent:
When you are able to settle with a creditor by paying them less than you owe them, your financial situation may be bad enough that you owe, in general, more than you own. If you are considered financially insolvent in this way by the IRS, you may have either part or all of your debt excluded from taxation. If you believe that you may qualify for an insolvency exemption, you should hire a tax resolution professional to help make sure.

A canceled debt from friends or family:
If you borrow from friends or family and have them forgive the debt, the money forgiven is considered a gift and is not taxable income.

Tax-deductible interest:
If the debt that is forgiven includes interest that is tax-deductible, the interest component does not need to be reported as taxable income. Discharged student loans are also usually exempt from taxation.

Including the forgiven debt in your tax return

If you don't tell your tax professional about the forgiven debt, in most cases, you won't know about paying taxes on forgiven debt until you receive an IRS notice in the mail about it. Usually, a creditor who forgives over $600 sends you a 1099-C form stating the amount forgiven. The creditor also sends a copy of this form to the IRS. If the debt forgiven is exempt, you may need to fill out an IRS Form 982 to state how much should be exempt, and why.

What do you do if you pay taxes on forgiven debt that should be excluded?

If your debt is actually exempt from taxes, but you mistakenly pay the taxes, you're allowed to amend your tax return for three years. You simply need to file IRS Form 1040X and mention your exemption on IRS Form 982.

Working with forgiven debt can be complex. It is usually a good idea to hire a tax resolution professional to work out the details.

Our firm specializes in tax problem resolution. We do serve clients virtually so don't hesitate to reach out. If you want an expert tax resolution specialist who knows how to navigate the IRS maze, reach out to our firm and we'll schedule a no-obligation confidential consultation to explain your options to permanently resolve your tax problem. 

About the Author

Sheldon Lazarow

Tucson, Arizona tax attorney Sheldon Lazarow aggressively resolves individual and business IRS tax debt and audit problems.


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