When is Forgiven Debt Taxable?

A lot of Americans have fallen on hard times and are unable to pay their credit card debt. Sometimes the original creditor is willing to settle for a percentage of the original debt — 20% to 60% of the original sum, for example. It is also typical for an account to be turned over to an outside collections agency after 4-6 months of non-payment. Once the account goes to an outside collections outfit, it becomes very doable to settle the debt for as low as 20-30% without the help of a debt settlement company. Of course, “settling” is harmful to one’s credit report, but sometimes it’s unavoidable.

What is often a surprise to Americans is that the IRS considers forgiven debt taxable “income.” I shake my head at how the IRS defines “income.” The word itself derives from the concept of something “coming in.” If a credit card company cancels part of your debt, you don’t exactly have anything “coming in.” The dictionary defines income as “the monetary payment received for goods or services, or from other sources, as rents or investments.” In my book, canceled debt does not qualify as income. I think the IRS would tax me on the $10 my grandma sends in my birthday card if they could track it. I guess the IRS and I will have to agree to disagree about what constitutes “income.” At any rate, canceled or forgiven debt is generally taxable. However, there are certain situations in which forgiven debt is not taxable.

Forgiven debt is not taxable in the following situations:

• discharge of indebtedness in a title 11 case
• discharge of indebtedness to the extent insolvent
• discharge of qualified farm indebtedness
• discharge of debt connected with business real property
• discharge of qualified principal residence indebtedness
• discharge of indebtedness of a qualified individual because of Midwestern disasters

Today I’m going to focus on the second exclusion: discharge of indebtedness to the extent insolvent. This means that you do not have to pay tax on canceled debt to the extent that you were insolvent immediately before the cancellation. The question is how to know whether or not you were insolvent, and if so, by how much. Insolvency occurs when the total of your liabilities is greater than the fair market value of all of your assets immediately prior to cancellation of debt.

Example 1:

$15,000  Liabilities

$7,000  Assets

$8,000  Insolvent to the extent of

In this example, let’s say that a credit card company is willing to settle a $5,000 debt for 20 cents on the dollar. The debtor can write a check to the credit card company for $1,000, and none of the forgiven debt ($4,000) is taxable.

Example 2:

$10,000  Liabilities

$7,000  Assets

$3,000  Insolvent to the extent of

If a credit card company is willing to settle a debt of $5,000 for 20 cents on the dollar, the debtor can write a check for $1,000 to settle the debt. However, the amount of the debt forgiven ($4,000) exceeds the level of insolvency ($3,000). In this case, the taxpayer can exclude $3,000 of the $4,000 canceled debt from income under the insolvency exclusion.Tax will be due on the $1,000 of canceled debt that exceeded the level of insolvency.

An insolvency worksheet can be found on page 6 of IRS publication 4681, allowing the taxpayer to easily calculate the extent of their insolvency.

In my opinion, Congress should do away with taxing forgiven debt altogether. If you are in the position of having to settle a debt and trash your credit in the process, the last thing that you need is a 1099-C at the end of the year. In many situations, the little bit of cash a person has after settling their debts is consumed by the tax liability. Moreover, if there were no tax liability on forgiven debt, the debtor would have more money to work with in an effort to settle the debt. The banks could surely use that money these days.

The irrational — and I dare say immoral — practice of taxing forgiven debt should be done away with. It would relieve pressure on debtors, banks, and the courts.

As always, consult a tax professional.

Wade Young is the owner of RedDoorHomeLoans.com.