Many people are excited to hear that companies such as mortgage lenders, car financiers, and credit card issuers will write off their debt when they agree to pay a certain amount of the balance. It makes perfect sense–especially if the consumer is in a financial bind–to make such an arrangement. But what you may not know is that you still owe the IRS taxes on that write-off.
“When you settle a debt, or if a creditor forgives a debt by writing it off, the amount that was forgiven needs to be reported when you file your taxes,” says Mike Kidwell, vice president and co-founder of Myvesta (www.myvesta.org), a nonprofit financial management organization. “The amount is considered income since it was originally loaned to you and you do not have to pay it back.”
It is extremely important to file this income on your tax return. Your creditor will send a 1099-C or 1099-A form to you and the IRS for any forgiven amount over $600. If you do not report the write-off, the IRS will go back and make adjustments on your return, or even audit you or your business.
“Most people see the form that is sent to them and think since they’ve already cleared the debt they don’t owe anything else,” says Matthew Ware, CEO/accountant of Padgett Business Services of Atlanta located in Lithonia, Georgia. “If you have had a car repossessed, a home foreclosed, negotiated a lower interest payment on a mortgage or other loan, or had a credit card debt written off with the creditor forgiving or canceling the balance, you should look for the 1099 form to come in the mail.”
You will need to include the canceled debt as income on IRS Form 1040, line 21 for non-business debt, Schedule C or C-EZ for business debt, or Schedule F as an attachment to Form 1040 for farm debt. If you don’t receive the proper form from your creditor, use the documentation you received initially from the creditor to report the income on your tax return.
Under the tax code, there are some exceptions to this rule. One exception is on student loans for individuals who are going into the field of education and some fields of medicine. Also, a person or business that has filed Chapter 11 bankruptcy, has had debt canceled as a gift, or is considered insolvent does not report the canceled debt as income either. Additional exceptions can be found in IRS Publication 525 on Page 17. Log on to www.irs.gov and enter 525 in the “search forms and publications” box.
“It is important for people to know that the forgiveness of debt has tax consequences,” says Tim Harms, IRS spokesman. For additional information on debt settlements with creditors, Myvesta.org has a publication titled Beware of the IRS if You Settle or Default on a Debt. It can be downloaded free from the Website or ordered from Myvesta at P.O. Box 8587, Gaithersburg, MD 20898.