Forgiven debt may be taxable by the IRS, unless it fits an exception.

From credit card debt to student loans, any debt that is forgiven could be taxed by the IRS. The IRS considers forgiven debt a type of income. More specifically, the IRS defines this act as a cancellation of debt. According to the IRS, a cancellation of debt is any money borrowed from a lender which the lender later forgives or cancels. In these cases, the lender is required to file a Form 1099-C with the IRS. This form is also known as the Cancellation of Debt form.

So how do you know which forgiven debts are taxable? The Wall Street Journal addressed this issue, noting not only that the IRS keeps an eye out for taxable forms of debt forgiveness, but also that 1099-C forms can be filled out by lenders incorrectly. As a result, tax payers need to be aware of what forms of forgiven debt qualify for an exception and double check 1099-C forms for errors. These are not easy tasks. However, when watching for forms of debt that qualify, the following guidelines can help:

  • Home. In some cases, the Mortgage Debt Relief Act of 2007 can protect a taxpayer from added tax liability. This law was passed to help those who face financial difficulty due to mortgages used to "buy, build or substantially improve" a principle residence. The Act allows married couples to qualify for protection of up to two million dollars in indebtedness secured by the home.
  • Bankrupt. If an individual is struggling with credit card debt and is able to come to an agreement with the credit company that the borrower will pay off a certain amount and the creditor will forgive the rest, the forgiven amount is taxable. If, however, a similar agreement is made during a bankruptcy proceeding, bankruptcy laws may protect the borrower from additional taxation. The IRS specifically notes that debts forgiven through certain bankruptcy proceedings are not considered taxable income.
  • Insolvent. If the debt is more than the fair market value of the asset, the tax payer is considered insolvent. This can extend to include items like books, cars, homes, stocks and retirement accounts. The amount forgiven of an insolvent debt is generally not taxed.

These are just a few instances that can be exempt from taxation. Navigating through the various laws associated with taxes, insolvency and bankruptcy can be difficult. As a result, those who find themselves in these situations should contact an experienced bankruptcy attorney. This legal professional will be able to review your unique situation and help you consider which options are best for your financial situation.

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