If you settle a debt for less than the amount owed or the debt is forgiven entirely, the IRS considers that forgiven debt to be income. The rationale is that the borrower is now in a better position than if the loan had been fully repaid.
Creditors canceling debt of $600 or more are required to send Form 1099-C to the borrower and to the IRS by January 31 of the year after the debt was forgiven. The borrower is then required to pay tax on this “income.” However, there are some situations in which forgiven debt can be excluded from income. The most common exclusions are:
● Bankruptcy: Debts discharged in bankruptcy are not included in income. (But if the debts were canceled before filing for bankruptcy, they do not qualify for this exclusion.)
● Insolvency: The forgiven debt is excluded to the extent that liabilities are greater than assets. (For example, a person with $30,000 of assets and $40,000 of liabilities can exclude up to $10,000 of canceled debt.)
Borrowers who qualify for an exclusion must file Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). There are also some “exemptions” in which the forgiven debt is not income and the borrower does not need to file Form 982. Common exemptions include:
● Student loans: If there is a loan forgiveness provision based on service in a certain field of work, the canceled debt is not income.
● Family and friends: if the debt was between family members or friends, the cancellation of the debt may be considered a gift. (But the creditor may have to file a gift tax return and pay gift tax.)
● Forgiven interest that would have been deductible (such as interest on business debt) is not taxable.
If you already paid taxes on forgiven debt despite qualifying for an exclusion or exemption, you could go back and amend the prior year’s tax returns (for up to three years) and you could get a tax refund.
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