Understanding Debt Cancellation & Debt Forgiveness

When you lose your job or have an unexpected injury or illness, the result can be financial devastation. Such financial demise often leads to a debt settlement agreement or even bankruptcy. While this may seem like a good idea, there can be some stiff penalties for relief such as debt forgiveness.

When a creditor agrees to forgive a debt without consideration in return, it means that they cancel the debt. While that may sound good to start with, cancellation of debt is considered income for the debtor and is taxable. In some cases, however, the cancellation or debt forgiveness is considered a gift or exception, such as in the case of some farm loans, bankruptcies, and other situations.

In most situations, you will receive a 1099-C form from your creditor and will have to report that form to the IRS. Common situations in which you might receive such a form include:

  • Repossession
  • Real estate short sale
  • When property is returned to the lender
  • A loan modification where the principal was forgiven

Exceptions to the Rule

If you are lucky enough to be an exception, there are a few situations in which you can avoid the tax implications of debt cancellation. These exceptions include the following:

  • You were insolvent when the debt was canceled: This option often surprises people since most debts are forgiven because the people can not afford to pay them. However, this does not necessarily mean that they were all insolvent. An experienced attorney can help you determine if your situation would qualify you for insolvency.
  • Your debts are discharged in bankruptcy: This one is fairly simple. If you received a discharge through bankruptcy, this discharged debt does not count as income.
  • Students loans that are forgiven after you have been working for a certain amount of time: Some student loans contain a provision based on the field of work you chose, and the debt may be canceled after you have worked in the field a certain amount of time. This canceled debt should not be counted as income.
  • The interest that was forgiven that would have been a deduction: If you do not pay taxes on the portion of debt that is due to interest, you could deduct the interest if you paid it. If, however, you could not have deducted the interest, you will have to pay taxes on the interest and debt that was forgiven.
  • Debts that were canceled as a gift: As a general rule, the IRS will believe that it is a gift if it was made between family members or friends. Relationships that are strictly working relationships are likely not to be allowed as gifts.
  • Farm and business exclusions: If your debt cancellation was connected to your farm or business real estate and you were forgiven when you owed more on the property than what it was worth, you will not have to pay taxes on the canceled debt.

Consult with an Experienced Debt Relief Attorney Today

If you have received a debt cancellation, the attorneys at Cornwell Law Firm can advise you what your tax obligations and other repercussions may be. Contact our office today to schedule a consultation and ensure that you are making the right decisions regarding your finances.

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