Debt Forgiveness and Your Tax Obligations

MM Proposition 2 with risky debt and no taxes

MM Proposition 2 with risky debt and no taxes (Photo credit: Wikipedia)

The official IRS website begins one of their articles about debt with, “If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable.” The key words in this statement are “may be taxable.”

Therefore, you may ask yourself this question, “Will you have to pay income tax on forgiven or canceled debt?” The answer to the question depends on whether or not you file for bankruptcy protection.

Here are some of the possible answers on debt forgiveness and your possible tax obligations:

If you file for bankruptcy –

  • All Debts discharged through bankruptcy are not considered taxable income.

If you have not filed for bankruptcy-

  • When you can prove you are insolvent at time the debt is written off, you will not have to pay taxes on the amount written off. You are insolvent when your total debts are more than the fair market value of your total assets.

  • When you have a qualified principal residence indebtedness, on any deficiency occurring because of modification on you loan or a foreclosure on your property, you will not have to pay the taxes on these deficiencies through 2012.

  • When you incur certain farm debts, if more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your canceled debt is generally not considered taxable income.

  • There may be tax consequences if you are forgiven deficiency debt in a non-recourse loan.

If creditors write off a debt, they are required by the IRS to send you a 1099-C, cancellation of debt form. The 1099-C informs you that you have an obligation to pay income tax on the amount forgiven.

Instead of writing off a debt, some creditors may attempt to collect on the debt by either selling the debt or getting a deficiency judgment against you in a court of law. In either event, you may or may not be obliged to pay taxes for any deficiencies in the collection process.

Although these taxes may not result from the forgiveness or cancellation of debt, there are certain taxes that are tax exempt from the bankruptcy process. In these cases, you will not be able to get a discharge of the debt, and you will still be obligated to pay the taxes.

Other than paying your taxes when you incur debt forgiveness or cancellation, there are two kinds of professionals that can help you the most when you are facing these type of problems- a tax lawyer or a bankruptcy lawyer.

Filing for bankruptcy protection is the easiest and simplest way to deal with debt forgiveness and the taxes that result from them. Before you choose this method of dealing with such issues, it would be wise to consult with a bankruptcy attorney who can help you answer any questions about your particular situation.

Enhanced by Zemanta
The following two tabs change content below.