Sometimes, no matter how carefully you manage your finances, circumstances lead to falling behind on paying back the money you owe. This could look like missed payments for your car, credit card, student loans, or even your mortgage.
Depending on your circumstances, you may find yourself with canceled debt. While this can be helpful for getting back on financial track, there can be some IRS tax implications that you will need to prepare for.
What Is Canceled Debt?
If a creditor doesn’t believe the full amount due can be recovered or if the debtor files for bankruptcy, sometimes part or all of the debt owed can be forgiven. This is known as canceled debt.
Canceling debt can sometimes be done directly through the creditor, negotiated on your behalf through a debt-relief program, or ordered by the courts in the case of bankruptcy.
Forgiven debt is often involved in settlement agreements, where the creditor accepts a lump sum to recover part of the money owed and cancels the remaining amount.
Debts attached to real property, such as a vehicle or home, can be canceled as part of the foreclosure or repossession process.
However, if the real property is recovered by the creditor, it is treated as a sale back to the creditor by the IRS. If you are liable for the debt personally, you are given credit for the recovered property’s market value.
Any balance exceeding this is considered canceled debt if not paid. If you are not liable for the debt personally, the recovered property is considered payment in full and there is no cancelation of debt.
Is Canceled Debt Taxable?
The short answer to this question is yes. Generally, canceled debt is considered income by the IRS and requires a 1099-C form to be included with your taxes if the amount exceeds $600.
However, the IRS offers several exceptions that provide relief. Student loans that meet the standards set by the IRS may not be considered canceled debt along with any discharges in the event of a student’s disability or death.
Any debt that would be considered deductible if paid is also exempt from being taxed. If the debt being canceled is classified as a gift or inheritance, it is also tax-free.
In some cases, the IRS still classifies the financial situation as a canceled debt but allows the amount to be excluded as reportable income. This includes canceled debt from Chapter 11 bankruptcy and qualified indebtedness from farms, your principle residence, and real property business.
Reporting Canceled Debt for IRS Taxes
Whatever your circumstances, it’s important to handle your canceled debt appropriately on your taxes. Making a mistake can result in penalties and fees, making it more difficult to reach the financial recovery the forgiven debt was meant to help you achieve.
1099-C for Canceled Debt
Any creditor who forgives an amount equal to or greater than $600 will send you a 1099-C form for preparing your tax return. It’s important to note that amounts less than this, although they may not trigger a form being sent to you, are still required to be reported if they are not exempt.
The taxable canceled amounts should be included on the line labeled as “other income” on the 1040 tax form. This must be reported on your taxes for the year that the debt cancellation took place.
How Canceled Debt Can Impact Taxes
Canceled debt affects your taxes the same way most other sources of income do. It increases your gross income, generally raising your tax liability based on this higher amount. This is why it’s important to know whether your debt forgiveness amount qualifies for being exempt as income on your taxes.
If you are anticipating a refund for the tax year that includes the canceled debt, the impact on your refund will depend on the level of change on your taxable income.
The IRS will not withhold your refund just because you have reported a forgiven debt, but the refund may be reduced if taxes you owe go up because of your higher gross income amount when your debt is canceled.
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