According to the Federal Reserve, consumers’ credit card debt in the United States surpassed $1 trillion in the past two years. At the same time, the student loan debt situation is even worse. Americans owe more than $1.5 trillion in student loans. If you are one of the millions of people affected by debt, chances are you are desperate to find the solution as quickly as possible. Fortunately, debtors have several options to help relieve their debt. Ideally, you should thoroughly explore all possibilities and choose the option that will be best for your particular case.
Below, we’ll discuss one of the debt relief options available: cancellation of debt. Depending on your circumstances, you may be eligible to have all or part of your debt canceled or forgiven by the creditor. Although debt cancellation might appear as the most desirable option for anyone in debt, it comes with certain tax implications for the debtor that you must know about. Your canceled debt is usually considered as income for tax purposes, and you might have to pay taxes on the forgiven amount. Understanding how the process of debt cancellation works and how it affects you can make the journey of getting out of debt a lot smoother and faster.
Debt cancellation is not an option available to anyone who owes money. Rather, it is an option that you resort to in the case of extreme financial hardship. In particular, when the debt becomes large enough that it cannot be repaid, the borrower may be forced to negotiate with the lender for the cancellation of some or all of that debt.
However, not being able to repay your debts is not a guarantee that your lender will cancel your debt. Many factors will come into play when determining whether your debt can be canceled or not. These factors include your income and profession as well as the amount you owe and the origin of your loan. According to the office of Federal Student Aid, for instance, your federal student loan may be canceled if you work in education or public service. Try exploring various resources to find out if your particular debt is eligible for cancellation.
Although it might be challenging, you could negotiate debt cancellation with your lender directly. Doing it yourself requires a strong commitment to the process, serious efforts, and in-depth financial knowledge. You will have to be familiar with all possible options for debt relief and various provisions in your credit agreements. If you can’t devote enough time and effort, you can have a debt relief company negotiate on your behalf. You can also have your debts canceled through debt relief programs or by filing bankruptcy.
Although getting your debt canceled is a great relief for anyone in debt, you should learn how it will affect your tax return. This way, you will avoid unpleasant surprises that could put you back in debt. Generally, when debt is canceled, it is treated as a taxable income because the borrower, in essence, received money on which they did not previously pay taxes. As such, it is a good idea to plan for your taxes as you are getting your debt discharged.
Later, we’ll go over certain canceled debts that don’t count as taxable income. However, you should try preparing and taking important steps ahead of time to start your debt-free life on the right foot.
Debt cancellation applies to all kinds of debt, including credit cards, student loans, medical costs, and mortgage loans, just to name a few. It also applies to certain debts for which the borrower is liable only up to the value of the property that secures the debt, such as a mortgage loan. A debt secured by a property may be canceled when the mortgage loan is extinguished as a result of a foreclosure, repossession, voluntary return of the property to the lender, or abandonment of the property.
When your debt is canceled, the lender will generally report the canceled debt to you and the IRS on Form 1099-C (Cancellation of Debt). However, the IRS requires lenders to file the form only when canceled debts amount to $600 or more. Form 1099-C must be sent to you by the end of the tax year, which is Jan. 31. The form should include all the pertinent information regarding the canceled debt, including the original amount of the debt and the amount you paid. The lender has until the end of February to send a copy of Form 1099-C to the IRS.
Once you receive Form 1099-C, make sure you carefully review all the amounts listed on it. If you believe some of the information listed on the form is incorrect, you should promptly get in touch with the lender to correct such information. If the lender does not correct the information on Form 1099-C, you should report the amount on your tax return and also attach an explanation about why the lender’s information is incorrect.
If you do not receive your Form 1099-C on time, you should contact the lender and request a copy. Don’t assume that just because you did not receive a copy, you are not obligated to report the canceled debt as income on your tax return. Even if you did not receive Form 1099-C, it is very likely that the IRS did.
If you are aware of canceled debt during the applicable tax year but did not receive Form 1099-C, you should list any such debt on your tax return. On the other hand, you may have received Form 1099-C even while the creditor is still trying to collect the debt or before the debt is actually canceled. If you are not sure, you should contact the lender or the creditor to verify the status of your debt and whether it has been canceled.
Not all canceled debt is considered taxable income. Tax treatment of your debt will largely depend on the type of debt, how you acquired it, and your particular circumstances. Listed below are several examples of exceptions and exclusions to treating the canceled debt as taxable income. If you are not sure whether your canceled debt qualifies, you should consult a tax professional.
There are several exceptions to including canceled debt as taxable income. Those exceptions include:
There are also certain canceled debts that may be excluded from gross income. If you claim one of the exclusions, you need to complete and attach Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) to your tax return. The exclusions include:
Note that excluding canceled debt under these provisions requires you to reduce tax attributes, such as certain credits, losses, and basis of assets.
Debt cancellation is a complicated process, and whether canceled debt qualifies as taxable income depends on a variety of factors. Different types of debt may have different tax treatments. If you fail to correctly report the taxable amount of the canceled debt, or if you fail to pay taxes on any taxable amount, the IRS may assess additional penalties, tax, or interest. Accordingly, if you are unsure of how to treat your canceled debt on the tax return, you should consult a tax professional.
Hopefully, now you have a better idea about what debt cancellation is, how the process works, and what you can expect as a result of it. As you can see, it is not easy to get your debt canceled. Even when your particular debt qualifies for a discharge, you still have to put a lot of effort into the process and familiarize yourself with various rules and regulations for filing your taxes afterward. Essentially, by going through the debt cancellation process, especially on your own, you are also going through some rigorous financial training.
If you are serious about getting out of debt, try investing some time and effort into the process, whether you are going solo or getting help from a debt relief agency. Although you might feel overwhelmed at the beginning from the influx of information, you will become more comfortable and confident as you progress and learn everything there is to know about debt. Ultimately, the knowledge and experience you gain during the process will prove priceless for maintaining a debt-free life afterward.
If you are struggling with debt and keep falling behind on your bills, feel free to contact debt specialists at Solvable. We will be happy to advise you on all available tax relief options and the best strategy for getting out of debt for good.