Forgiveness of debts, also known as debt cancellation, is a relief to anyone who has been in debt. But what happens afterward with the taxes? When your debt is canceled or forgiven, it could also mean you get to pay way less than the amount owed. Now according to the IRS, there are tax laws for exemptions regarding canceled debts.
However, the amount you wouldn’t have to pay is NOT a “Canceled debt.” The cancellation of debt happens when the creditor cannot get the money or gives up the amount of money you should pay back.
There are several other examples of debt cancellation aside from monetary debts. For example, if you have a property that is subject to an obligation, the cancellation may happen due to several reasons:
Foreclosure
The voluntary transfer of ownership to the lender
Repossession
Property abandonment
Mortgage modification
Generally, if you’ve got a cancellation of debt income due to a forgiven debt, the amount of the canceled debt will be taxable. You must also report the canceled debt when filing your tax returns for the year that the cancellation happened. But the canceled debt will not be taxable if the specific law allows you to dismiss it from your annual gross income.
After the debt is forgiven, the creditor will send you a ‘Form 1099-C, Cancellation of Debt” from the IRS, which stipulates the amount of canceled debt with the date of cancellation. The creditor will also input other details that the form requires, so please check that all information is correctly written.
If there are incorrect details, please get in touch with the creditor to make corrections. For instance, if the creditor is still trying to collect the debt even after sending you the Form 1099-C, it could mean that it isn’t completely forgiven. This also means that you wouldn’t have income from the forgiven debt. You will need to verify such information with the creditor.
You also have a responsibility to report all taxable amounts of the forgiven debt as income on your annual tax return when the cancellation happens. This requirement doesn’t change irrespective of you receiving a correct Form 1099-c or not.
You also expect to report the taxable income amount of forgiven debt as “Ordinary income” from the canceled debt: this should be on Form 1040 or Form 1040-SR. If it is a nonbusiness debt, then you should read Publication 4681 for details.
If you secured your debt with a property and the creditor takes possession of the building fully or partially, you will assume that you sold the property to the lender. This also means that your tax treatment will depend on if you were individually liable for the debt (which is a recourse debt) or if you were not individually responsible for it (nonrecourse debt).
So if your property is subject to recourse debt, the amount of money gotten from it will be a fair market value (FMV). Your regular income from the debt cancellation will be the amount of the debt over the property’s FMV, which the creditor forgives. The IRS requires that you include such cancellation of debt in your income unless there is an exception.
Contrarily, if the property is nonrecourse debt, the derived amount will be the entire amount of the nonrecourse debt as well as the amount of cash and the property’s FMV you received. There will be no regular income from this kind of debt cancellation.
So here you are getting excited about the possibility of the creditor forgiving your debt; as the excitement dies down, remember to find out how this affects your taxes. Discover the peculiarities of the canceled or forgiven debt and what the IRS expects from both you and the creditor.
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