Debt Forgiveness and Taxes

In 1726, author Daniel Defoe wrote in “The Political History of the Devil” that, “Things as certain as death and taxes can be more firmly believed.” A modern twist on that time-honored quotation would be, “Few things can affect your taxes more than debt.”

Exactly how much debt are we talking about? As of March 2014, according to the Federal Reserve, total consumer debt is more than $3.09 trillion, or about $1,000 for every man, woman, and child in the United States. The actual average debt of working adults is just over $8,000 per person. There are close to 1 million personal bankruptcies a year and countless others who are granted some form of debt forgiveness by creditors, including mortgage lenders.

Lifesaver or Anchor?

Many people drowning in debt look for a lifesaver, something to help them stay afloat while they catch their financial breath and swim to the shores of fiscal safety. That lifesaver often arrives in the form of debt forgiveness, short sale, and foreclosure, each of which appears to help you escape the yoke of oppressive debt. They are viewed as a way to wipe the slate clean and start over.

Taking advantage of debt forgiveness opportunities — where you pay a percentage of what you owe and the remaining unpaid balance is forgiven — comes at a price. Too often, consumers reach for debt forgiveness only to find they are being dragged deeper into the financial abyss by the side effects of these programs.

What Happens When You Default?

There are times, short of bankruptcy, when people find themselves unable to pay off debt and, through negotiation with creditors like banks and credit card providers, reach an agreement to pay a portion of what they owe and have the rest of the balance forgiven. That’s what debt forgiveness is: excusing all or part of an outstanding debt.

The reasons why creditors will do this include the expense of chasing you versus what you owe, and providing them with the tax advantage of a loss.

Debt forgiveness sounds like a good deal, but a fresh start can be more damaging to your credit than working out a long-term installment agreement.

Many people believe it is better to have no debt on their credit report than lots of debt being paid off slowly. That could not be further from the truth.

The fact is, making a long-term payment arrangement with a credit card company may not boost your credit score at first, but it won’t lower it dramatically either. Besides, if you stick to your agreement and make your new lower payments on time, in the long run your credit score will go up.

The Tax Man Cometh

Debt forgiveness, short sales, and foreclosures can have another unintended consequence – a tax bill.

Every year, accountants around the country have the uncomfortable task of explaining to clients that they have a substantial tax bill because of debt that has been forgiven. That’s because the IRS considers forgiven debt to be income and expects taxes to be paid on it.

If you owe $10,000 to a credit card company and they agree to accept $2,500 as payment and forgive the balance, the IRS will consider the $7,500 to be taxable income. Depending on your tax bracket, this can amount to a tax bill of a couple of thousand dollars or more.

There are some exceptions to the IRS’ canceled-debt rule that include:

  • Certain qualified student loans: This generally applies to student loans that are forgiven in exchange for public service such as the Peace Corps.
  • Deductible debt: This applies to debt that would have been tax-deductible had you repaid it.
  • Qualified farm debt: Criteria include incurring debt as the direct result of operating a farm, or you lost half your gross receipts for the previous three years from farming.
  • Principal residence indebtedness: This refers to forgiven mortgage debt covered under the Mortgage Debt Relief Act of 2007.

Mortgage Debt Relief Act of 2007

This law generally allows taxpayers to exclude debt on their principal residence from their income, but the rule does not apply to second homes or investment properties. The act was originally due to expire on Dec. 31, 2012, but has been extended twice.

The act excludes as income any qualifying mortgage debt up to $2 million that has been forgiven. The act includes not only foreclosures but debt relief that was obtained through restructuring of loans and partial forgiveness. Taxpayers are eligible to refinance, but only up to the amount of the principal balance of the original mortgage. In addition to mortgages, the act also covers debt forgiveness for loans that were taken to make home improvements.