The Surprising Dark Side of Forgiven Debt

Image: Alan Cleaver, Flickr.

When you have a debt forgiven, it can seem like a wonderful thing. A weight is lifted from your shoulders, and your financial worries will likely feel smaller. But there's a bit of a dark side to forgiven debt as well: It can be taxable.

Imagine that you owe $15,000 on a car and are having trouble making your payments. Your car gets repossessed and the lender sells it, netting $12,000. The $3,000 difference is called a deficiencybalance, and you will now owe the lender that much. But let's say that you strike a deal with the lender and have that debt forgiven. If so, Uncle Sam will usually view that $3,000 as taxable income to you.

It's the same if you're struggling under a mountain of credit card debt. Sometimes in such situations, you can negotiate with your lender, and have some of your debt forgiven. If so, that's often considered taxable income, too. To further complicate matters, you might not even be aware that a debt was forgiven. If a collection agency, for example, has stopped attempting to collect a debt from you, it might declare it uncollectible and report it to the IRS as lost income.

Nuts and boltsFirst, know that reporting forgiven debt isn't an optional matter. If a lender forgave $600 or more of your debt's principal, they will probably send you a 1099-C form, for canceled debt. Because they'll likely also report the canceled debt to the IRS, so you can be sure the government will expect you to report it on your tax return -- via Form 982. (Our National Taxpayer Advocate has noted that there have been errors on 1099-C forms -- and sometimes duplicate forms sent out -- so be sure to verify the information on it, lest you end up overpaying taxes.)

Fortunately, there are some exceptions to the rule of forgiven debt being taxable. An exceptional exception has been the Mortgage Debt Relief Act of 2007, which has been extended several times, and is now in effect through 2014. It allows people to exclude from their taxable income canceled debts that came about through a mortgage debt restructuring or foreclosure. (Debt used for refinancing can sometimes qualify, too.)

That has saved many people who have had underwater mortgages from being taxed on some huge sums, often more than $100,000. Legislation has been introduced to extend the relief through 2016, so if this might affect you, keep an eye out for news about it.

Farming-related canceled debts might not be taxable. Photo: Andrew Stawarz, Flickr.

Now let's review some of the standard exclusions. (The IRS offers a more comprehensive review of them.)

Bankruptcy: If you discharge certain debts through a bankruptcy, they won't count as taxable income.
Insolvency: If you're insolvent, meaning that your total debts outstrip the current value of your total assets, then some or all of your canceled debts may be exempt from taxation.
Farm-related debts: Not all forgiven farm debt qualifies, but yours might, especially if more than half your income in the past three years has been generated by farming, and if the debt was incurred "directly in operation of a farm."
Non-recourse loans: If you have non-recourse loans forgiven, where the lender isn't legally allowed to pursue repayment from you other than by repossessing property, then they may not count as taxable income.
Student loans: Canceled student loans are generally considered taxable income, but if some or all of your student loans were forgiven in exchange for your agreeing to work in a certain occupation for a certain length of time -- for example, as a doctor in an underserved region -- then it may not be taxable.

If you think you may be eligible to exclude forgiven debts as taxable income, or you want to learn more in order to find out if your debt qualifies, you should consult with a tax professional. Otherwise, do some digging on your own at IRS.gov, to learn more about this possible tax break. And if you owe taxes on forgiven debts, be sure to report and pay them.

The article The Surprising Dark Side of Forgiven Debt originally appeared on Fool.com.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter,has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.