Borrowers occasionally get in over their heads. Perhaps you lost your job or you got a divorce and you no longer have the income to pay off your debts. In certain circumstances, the creditor may agree to forgive, or cancel, all or a portion of the money you owe. However, this does not mean you're in the clear.
Process
Settling a debt with a creditor for a small portion of what you owe may satisfy the creditor, and he may cancel the outstanding part of your debt. If you're having financial difficulty, this may be a way to get the creditor off your back, but in some cases you may have to pay taxes on the canceled debt.
Types
Typical types of debt forgiveness include charges on credit cards or on personal accounts at local retailers. Mortgage debt forgiveness occurs when the bank forecloses on your home, sells it at a loss and then cancels the balance you still owe on the mortgage. Mortgage debt forgiveness may also occur as a result of a short sale, where you accept a lower offer for your home than you owe the bank and the bank takes part in the negotiations.
Taxes
Debt forgiveness may prevent bankruptcy for many individuals even if they must claim the canceled portion of the debt as income on their taxes. The creditor will deduct the loss from his profits, and he will file an IRS Form 1099-C notifying the IRS with his income taxes. The IRS uses the 1099-C to cross-reference the income you claim on your taxes.
Exclusions
Not all canceled debt is taxable. If you were insolvent, meaning that you had more debts than you could pay, you may not have to pay taxes on the forgiven debt. If the creditor canceled the debts as a part of a bankruptcy, you are not required to pay taxes on the amount. In addition, the IRS may exclude farm debts from taxation.
Mortgage Forgiveness and Debt Relief Act
Due to an economic recession and reduced home values, home sellers with forgiven debt on home mortgages between the years 2007 and 2012 will not pay taxes on the canceled amount. After 2012, contact an accountant about the taxation of forgiven debt.
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