The Taxable Downside of Debt Forgiveness

Jennifer Waters for the Wall St. Journal writes: You may have shored up your finances by settling most nonmortgage debt with creditors in 2012, but there's no escaping the tax man: The Internal Revenue Service expects you to pay taxes on that dodged debt, which is now considered "income."  "When you borrow money it's not a taxable event because it's assumed you will pay it back," says tax attorney John Foley, a partner with Tatooles, Foley & Associates in Chicago. "But with any type of debt relief, you do have income because it's an enhancement to your balance sheet."  That's true even if it's purely on paper as an accounting item and not cold, hard cash in your hands. The IRS considers any forgiven debt of $600 or more as taxable income. There are exceptions, but they're limited and require more paperwork.

Consider it this way: You ran up $15,000 in credit-card debt and have only paid back $5,000. If the lender is unable to collect the remaining debt and writes it off as a loss, you're expected to pay the taxes on the $10,000 that has been forgiven.

The IRS considers that $10,000 of debt relief as a revenue windfall because you used that money to buy stuff, like clothes, dinners at nice restaurants or a new bike, and you no longer have the obligation to repay it.

Lenders must report the amount of the irrecoverable debt to the IRS and to you on Form 1099-C, cancellation of debt. If you got debt relief in 2012, the lender should have mailed you this form, which must show the amount of the debt forgiven and the amount of the original debt or, in mortgage cases, the fair-market value of the home. You must report this on your tax return.

"Many people either don't think they have to [report] it or don't know about it," says Bill Hardekopf, founder of credit-card information site LowCards.com. "Chances are they never noticed the form and just tossed it out."

Also make sure the 1099-C form is correct. Nina Olson, head of the IRS's Office of the Taxpayer Advocate, has warned Congress that financial institutions have issued 1099-Cs for debts they haven't even tried to collect for some time or have forgiven. Some taxpayers have received duplicate 1099-Cs for the same debt and have found it difficult to reconcile with the IRS, according to Ms. Olson.

Debt cancellation isn't always a taxable event. The Mortgage Forgiveness Debt Relief Act of 2007, which excludes certain types of mortgage debt from taxes, got spared in the final hours of the so-called fiscal-cliff negotiations and was extended to the end of this year.

As a result, mortgage debt that was partly or entirely cleared from 2007 through 2013 isn't taxable. But this is only with mortgages that were used to "buy, build or improve" your principal residence, according to the IRS. It must be the home you live in most months of the year and it doesn't include second or vacation homes.

For example, if a home carrying a mortgage of $600,000 was sold for $250,000 in a short sale, the $350,000 remaining obligation that was canceled isn't taxable under the law. The same is true if the mortgage was restructured to a lower rate or forgiven in a foreclosure. Mortgages restructured under the Home Affordable Modification Program, or HAMP, follow the same general rules, according to the IRS.

The IRS maxes out the qualified home indebtedness at $2 million for couples filing jointly.

For divorced couples, the rules on canceled mortgage debt are uniform but applied differently. Using that same example, if $350,000 of the value of the debt is canceled, both homeowners will get the 1099-C. What they must do then is decide how they will split the responsibility. The easiest, of course, is a simple 50-50 cut, which means each will report $175,000 in canceled debt.

If you've used a home-equity line of credit for home improvements and the like, that too is spared of tax consideration if canceled. Be prepared to show documentation supporting those claims. Home-equity lines of credit used to pay off credit cards or buy a new car are taxable if canceled.

Though debt cleared on second homes, rental property, business property, credit cards or car loans doesn't pass the tax-forgiveness threshold, the IRS says that other tax-relief provisions—say, insolvency or bankruptcy—could be applicable. For example, if credit-card debt was absolved in a bankruptcy petition, the IRS won't consider that income.

Credit-card debt relief also can be tax-free if you're insolvent, meaning your total debts exceed the total fair-market value of all your assets—that includes everything you own, such as your home, car, furniture, jewelry, stocks, life-insurance policies, pension or other retirement accounts and investments.