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Debt Forgiveness Can Have Tax Penalties

When many people owe debt, they may have little financial option other than to negotiate the debt down to a manageable, payable amount. Sometimes this can include negotiating a waiver, forgiveness, or reduction of the debt. In the short term, the ability to pay off a debt for less than its full amount seems like a great financial windfall. But in the long term, there may be serious tax consequences to debt forgiveness.

The IRS and Debt Forgiveness

The IRS treats forgiveness of debt as income to you. For tax purposes, the amount forgiven is the same as if somebody put that dollar figure in your pocket as income. This means that if you negotiate a debt waiver, you could have negotiated yourself out of one problem and into another. Many consumers find that instead of owing the creditor money, they owe the IRS money. And as we know, the IRS can be a much tougher collection agency to deal with.

Exemptions to the Rule

For now, money forgiven on a homestead loan is not considered income. This was a reaction to the enormous foreclosure crisis; as consumers were negotiating debt waivers to get out of property, congress didn’t want to see them encumbered with a tax burden as if they had pocketed hundreds of thousands of dollars.

That exemption is still in effect, but comes up for renewal almost yearly. So if you obtain a waiver of a homestead property debt, make sure the law is still in effect. And if the property is not homesteaded, think twice before accepting any offer to waive large amounts of debt.

The IRS will not tax you for forgiven debt if you are legally insolvent. As a general rule, this means that if you subtract your debts from the value of your assets and come to zero, you are insolvent. Because many people don’t own property of significant value, this may be an option to avoid taxes on debt forgiveness.

There is also some authority that a disputed debt that is forgiven may not be taxable. But that requires more than a consumer claiming that the debt was disputed. Taxpayers will have to show that they legitimately disputed a debt, through writing of letters, filing of a lawsuit, or the taking of other actions showing there was a dispute.

Gifts are not taxable. In most cases, a creditor forgiving a debt won’t be considered a gift. But if the loan is from a family member or business partner, and it is forgiven in good faith, you may be able to demonstrate the forgiveness is a gift to you.

If a creditor forgives debt, you will be issued a 1099. But a 1099 doesn’t legally require a creditor to stop collecting the debt. If you get a 1099, make sure that the collector isn’t still seeking payment, as you don’t want to both owe the money, yet still pay taxes as if the debt was forgiven.

Make sure you understand the tax consequences of your planned actions. Contact Tampa business, tax, and probate attorney David Toback to discuss a comprehensive financial plan.

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