If you settle a debt with a creditor for less than the full amount, or a creditor writes off a debt you owe, you might owe money to the IRS. The IRS treats the forgiven debt as income, on which you might owe federal income taxes. (That additional income might also affect your state taxes.)
Here's how it works. Creditors often write off debts after a set period of time—for example, one, two, or three years after you default. The creditor stops its collection efforts, declares the debt uncollectible, and reports it to the IRS as lost income to reduce its tax burden. The same is true when you negotiate a debt reduction. The creditor will report the amount you didn't pay as lost income to the IRS.
Of course, the IRS still wants to collect tax on this money, and it will turn to you for payment. Because you no longer have to pay the full amount of the debt, the IRS treats the forgiven amount as gained income, for which you should pay income taxes.
This rule applies even to debts you owe after a foreclosure. In this situation, the law can seem especially cruel: Not only have you lost your property, but you might also have to pay income tax on the difference between what you originally owed the lender and what it was able to sell your property for (called the "deficiency") if the deficiency is forgiven.
To keep financially strapped homeowners from taking a second hit at tax time, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007 and I.R.C. §108(a)(1)(E) was added to the Internal Revenue Code, creating the Qualified Principal Residence Indebtedness (QPRI) exclusion. Under this exclusion, some taxpayers don't have to pay taxes for mortgage debt forgiven during 2007 through 2020, as well as debt discharged after that if a written agreement was entered into before January 1, 2021.
The exclusion provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the basic rules:
To learn more about the Mortgage Forgiveness Debt Relief Act, see Canceled Mortgage Debt: What Happens at Tax Time?
If you don't qualify under this exclusion, you might still qualify for tax relief. For example, if you can prove you were legally insolvent, you won't be liable for paying tax on the deficiency. See "Exceptions on Reporting Income," below, for details on the insolvency exception.
Any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable to interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for reporting income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income.
Even if you don't get a Form 1099-C from a creditor, the creditor may very well have submitted one to the IRS. If you haven't listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or, worse, an audit notice. This could end up costing you more in IRS interest and penalties in the long run.
The Internal Revenue Code has several reporting exceptions. For example, if the financial institution issues a Form 1099-C, you don't have to report the income on your tax return if you were insolvent before the creditor agreed to settle or write off the debt.
Insolvency means that your debts exceed the value of your assets. To figure out whether or not you were insolvent, you'll have to total up your assets and your debts, including the debt that was settled or written off.
Example 1: Your assets are worth $35,000 and your debts total $45,000, so you are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.
Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don't have to report $10,000 of the income, but you will have to report $4,000 on your tax return.
If you conclude that your debts exceed the value of your assets, include IRS Form 982 with your tax return. You can download the form off the IRS's website at www.irs.gov.
Tax laws are complicated, and an exception or exclusion might save you from having to pay taxes on canceled debt. If you have questions about whether your forgiven debt is taxable, consider talking to a tax attorney.