Another question I receive frequently is whether one has to pay taxes on debt discharged in a bankruptcy. The answer is no. That doesn’t make for much of a blog post, but it does segue nicely to the topic of where debt and taxes do come together. While debt discharged in bankruptcy is not taxable, when debt is eliminated outside of a bankruptcy it can be taxable.
One may choose not to file bankruptcy to eliminate debt for any number of reasons. A common alternative to bankruptcy is negotiating a settlement with creditors. This is not always an option and isn’t easy. Depending on the facts of a case, a creditor may be willing to accept a reduced payoff in exchange for quick payment of what they deem a significant amount of the balance. While I have settled debt where a client paid only about 15% of the balance, that is not the norm. One of the drawbacks to these settlements is that the portion of the debt that is forgiven is taxable.
Anytime more than $600 of a debt is forgiven, that creditor can issue a 1099-C form. This form is for the cancellation of debt, where the amount cancelled is then treated as income when you prepare your tax returns. I always guide my clients about this possibility, and take it into consideration in determining whether a settlement is in my clients’ best interests.
Once again, there are exceptions where debt forgiven is not taxable. The most common exception is insolvency. One is considered insolvent if his assets are less than his debt. The lookback at assets and debt is right before the settlement is paid. Note that if the debt forgiven renders you solvent again, you may be taxed on the portion forgiven that exceeds the debt.
Ex: You have assets totaling $100,000 and debt totaling $120,000. You are considered insolvent by $20,000. If a creditor then forgives $40,000 of debt, you are now solvent by $20,000 and that portion may be treated as taxable income.
Occasionally a creditor may issue a 1099-C after a debt is discharged in bankruptcy. As I noted earlier, debt discharged in bankruptcy is not taxable.
Sometimes mortgage debt is forgiven. In the case of a short sale, the bank is accepting a discounted payoff to allow for the sale of a house. If the bank forgives the remaining portion of the loan, they too can issue a 1099-C. After a foreclosure, if a home is sold but the purchase price at auction is not enough to pay off the balance of the loan and auction fees, the bank can go after the borrower for the resulting deficiency or forgive the debt. Again, they may issue a 1099-C.
Mortgage debt that was forgiven is not treated as taxable income by a Congressional act. The Mortgage Forgiveness Debt Relief Act was passed in 2007 during the Great Recession. That Act expired on December 31, 2017. It was extended in 2019 through December 31, 2020 and recently extended again through 2025. Prior to December 31, 2020, mortgage debt forgiven was capped at $1 million ($2 million if you file jointly) but the latest extension reduced that to $375,000 (or $750,000 jointly).
Fortunately, the IRS makes it easy to declare debt forgiven non-taxable. IRS Form 982 outlines the exclusions and when properly filled out will cancel out the “income” from a 1099-C. Over the years I’ve learned that not every tax preparer knows about this form or the exceptions and I find myself explaining it to my former clients so they can guide their tax preparers accordingly. That may be a sign that it’s time to find someone new to prepare your tax returns.
Disclaimer: I am not an accountant and do not provide any accounting advice. Always consult with a tax professional with any questions relating to how the information above applies in your individual tax situation.
Zimmelman Law PLLC
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