5 Exemptions Where You Don’t Need To Pay Tax on Forgiven Debt

In August 2021, about 64 million Americans with a credit record had debt in collections on their credit report. The number fell from 68 million in 2019. However, it's still significant.

If you find yourself in a similar pickle, you have two options: pay what you owe, or work with a debt relief company to help reduce your debt.

If your creditor forgives, wipes, or somehow manages to negotiate your debt and pay less than what you owe, you have certainly waived off an immense amount of stress from your head.

However, you should know that the Internal Revenue Service (IRS) counts this forgiven or wiped-out amount as income, and you are required to file this amount while filing your tax return.

But can you avoid paying taxes on forgiven debt? Typically, NO. But there are some exceptions and exclusions for which, if you qualify, you can reduce or avoid paying taxes.

For example, if you have debt related to your farm or real estate business and are planning to waive it, you can get a notable exclusion for the canceled debt.

Read ahead to learn more about the tax implications and the exemptions to paying taxes on forgiven debts.

Debt Forgiveness & Its Tax Implications

When you negotiate for debt reduction and your creditor agrees, they will write off a portion of your debt. If you default, creditors may also write off debt after a certain period - one, two, or three years.

In either case, the creditor stops its collection efforts, declares a part or all of the debt irrecoverable, and reports to the IRS the lost income to reduce its tax burden by filing a Form 1099-C, "Cancellation of Debt" (only if the reduced or canceled amount totals $600 or more). You will also get a copy of the Form from your creditor.

Even if the debt is less than $600 and you don't get a Form 1099-C, you must report your forgiven debt as your income on Form 1040.

Your creditor may relieve themself from their tax burden, but the IRS still wants its tax on the unpaid money. So, it will turn to you for payment.

The IRS treats canceled debt as income. So, when filing your tax return, you'll need to include the forgiven or canceled debt in your gross income - the sum of your earnings before taxes.

If you qualify for tax exclusions or exceptions and don't have to pay taxes on a forgiven debt, you may still get a 1099-C form. If this happens, you can use Form 982 to report the amount to exclude from your gross income.

5 Exemptions To Paying Taxes on Forgiven Debt

If your circumstance aligns with the following exemptions, you can reduce or avoid your tax liabilities.

Your Debt Is Forgiven Under the Bankruptcy Laws

In the case of bankruptcy, any debts the court discharges are not considered taxable. Say if the court cancels your $30,000 debt, you need not pay tax on the canceled debt.

But the IRS has a rule that if you file a return even one day late, they may not agree to the discharge, even if the court does.

"If you are considering filing for bankruptcy, it is important to speak with an experienced bankruptcy attorney to discuss your options and determine if this is the right option for you," says Antreas Koutis, Administrative Manager, Financer.

You Qualify As Insolvent

"One of the best ways to avoid tax on your forgiven debt is by getting your debt canceled due to insolvency," says Tiffany Homan, COO of Texas Divorce Laws.

The IRS thinks taxpayers are insolvent if their debts exceed their assets. If you believe you qualify under the insolvency exclusion, you must report the total value of your assets (including retirement plan) and liabilities before your debt is discharged.

Once you've tallied everything, subtract your assets from your liabilities to determine your insolvency. Your forgiven debt must be lower than your insolvency amount to exclude it as taxable income.

Example: "Your assets are worth $50,000 and your debts are worth $60,000, making you $10,000 insolvent. You reach a debt settlement with a creditor who consents to waive $7,000. None of that money needs to be listed as income on your tax return," says Tiffany.

Although, most insolvency cases need to be more clear-cut. If you are eligible for an insolvency exemption, consult a tax expert.

Your Debt Is Canceled As a Gift

Suppose you borrow money from a friend and agree to pay it back by signing a promissory note. Your friend dies, and his will releases you from paying back the loan.

When this happens, the IRS won't count the debts forgiven as income. However, the IRS strictly assesses the relationships and confirms that they are not working relationships.

Note: If a debt of more than $16,000 is canceled as a gift within a year, the gift donor is generally responsible for paying the gift tax. But if the donor fails to pay the tax for some reason, the person receiving the gift may have to pay the tax.

Your Student Loan Is Forgiven Under the PSLF Program or Due to Permanent Disability

Under the Public Service Loan Forgiveness program, you may be able to get rid of all your student loans if you have worked for the government (federal, state, local, tribal, or a non-profit) for at least ten years.

You don't need to pay taxes on this forgiven student loan.

The U.S. Department of Education and some private lenders may cancel your student loan debt if you are rendered permanently disabled.

Due to an alteration in the tax law, loan balances discharged because of a borrower's permanent disability will no longer be counted as taxable income until December 31, 2025.

A Portion of Your Mortgage Debt Is Canceled Due to Foreclosure

Say thanks to the Mortgage Forgiveness Debt Relief Act of 2007, as now you need not pay tax on debt forgiven when you lose your home.

For instance, if your bank realizes an amount less than you owe after selling your home, the bank would report the amount as canceled debt that they could not retrieve.

Fortunately, because of the Mortgage Forgiveness Debt Relief Act, canceled mortgage debt is not considered taxable income.

In Conclusion

You might think your problems are over if your loans or credit card debts are forgiven. But you still have one thing to worry about - income tax.

The tax on canceled debt can be a big problem for you if you're already having trouble paying your bills. So, you must try to make the most of the tax exemptions.

Did you know if you got a Paycheck Protection Program loan and your creditor forgives your debt, you don't have to pay taxes on the amount?

Under the Coronavirus Aid, Relief, and Economic Security Act, any forgiven amount cannot be counted as taxable income.

You can avoid extra payments by just knowing which types of canceled debt you can leave off your tax return and making the correct claim at the right time. But we know it's easier said than done.

So, if you're finding these tax implications overwhelming, take the help of a tax expert. They can guide you and ensure you pay what you owe and not a penny more.