Debt forgiveness isn't free

This article is presented for informational purposes only and is not intended as tax or legal advice.

If you’ve got any kind of debt – small debt, big debt, crippling debt – you’d probably like to see it disappear. Instantly. No years of struggling. No lean budgets. Just gone. Sayonara debt!

Debt forgiveness is a worthy dream, and in some instances it’s even possible. But debts when forgiven are rarely forgotten, and even when your creditor walks away, there’s usually still a significant price to be paid.

When is a debt forgiven?

Debt forgiveness can come in many forms. When a loan or credit account goes into default and the creditor (usually after many years and many attempts to collect) decides, “You know what? This isn’t worth it,” your debt may be considered forgiven – which is to say, no one is coming to collect that money anymore.

If you have an account in collections, you may also attempt to negotiate with the collector by offering to pay a portion of the debt in exchange for having the remaining debt forgiven.

If you foreclose on your home, the balance remaining on your mortgage may be considered forgiven debt.

On certain federal student loans, if you’ve made the required payments over a set period of time (usually between 10 and 30 years), whatever is left of your remaining balance may be forgiven.

Essentially, in any scenario where you owe money and don’t eventually make a full repayment, part or all the remaining balance may be considered forgiven debt.

The Tax Man Cometh

Just because you’re square with your creditors doesn’t mean you’re square with the government. Forgiven debt is almost always considered to be taxable income.

How can debt be income? you may ask. Well, I suppose you have to look at it this way – you were provided with money, goods, or services in the amount of your debt. If you had $10,000 in credit card debt and only paid back $6,000, with $4,000 being forgiven, from a tax perspective you got a free $4,000. But of course, nothing is actually free, so now you need to pay taxes on that $4,000.

Any time a creditor forgives a debt in excess of $600 they are required to send you a 1099 form reflecting the amount of the forgiven debt, which you must then add to the “Other Income” section of your personal tax return for that year. It should be noted that creditors are required to send you this form because they themselves are claiming your forgiven debt as lost income. If you have a forgiven debt that’s less than $600 you still need to claim it on your taxes – creditors just aren’t required to send notification in that instance.

The impact on your tax return could be major or minor, depending on a lot of factors, such as your income bracket and the amount of the forgiven debt. If you have questions or concerns about how to complete your tax return, be sure to speak with a qualified tax professional.

Exceptions to the rule

You should generally assume that if your debt is being forgiven, you are going to have to pay taxes on the balance. But there are definitely exceptions to that rule.

Your forgiven debt might not be taxable if:

It is a result of a personal bankruptcy. All debts discharged through bankruptcy are generally not taxable.

It is the result of a foreclosure on a primary residency between 2007 and 2014. Foreclosure usually results in the remaining mortgage being considered taxable income. However, the Mortgage Forgiveness Debt Relief Act of 2007 was created to prevent families already dealing with the nationwide economic downturn from essentially being hit twice – first by losing their home and then by being taxed in the fallout. The act was renewed a few times, but expired on December 31, 2014.

You are insolvent in an amount greater than the forgiven debt. Insolvency is when your debts outweigh your assets. If you currently owed $10,000 more in debt than you held in assets, and then had a creditor forgive $3,000 in debt, you would not have to claim that $3,000 as additional income. If they forgave $11,000 in debt, however, you would have to claim $1,000 as income.

You completed the terms of a career-specific student loan repayment plan. If you made all of the required payments on a public service loan forgiveness, teacher loan forgiveness, law school loan repayment assistance, or National Health Service Corps Loan Repayment program your forgiven debt is not considered taxable. Any forgiven debt resulting from any other student loan repayment plans, however, including income-based and income-contingent plans, is taxable.

There are a few other unique exceptions, including exceptions for farmers and borrowers using non-recourse loans, but those relatively rare. Again, if you have specific questions about how debt forgiveness may impact your personal tax return, please contact a tax specialist. It’s what they do.

In almost every case, the benefit of a forgiven debt far outweighs the tax consequences, but it’s important to be aware of those consequences and plan accordingly. Free money almost always costs you something in the end.

Jesse Campbell is the Content Manager at MMI, focused on creating and delivering valuable educational materials that help families through everyday and extraordinary financial challenges.

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