- When the creditor files its business taxes, it claims your unpaid debt as a loss. This lowers the company’s tax liability. The Internal Revenue Service, however, will hold you liable for the taxable portion of the unpaid debt. Provided your forgiven balance exceeds $600, the creditor will send you a 1099-C during tax season. The 1099-C notes how much of your debt the creditor wrote off. When you receive your 1099-C, you must include the written off amount as income for the year and pay taxes accordingly.
- The law only requires creditors to send you a 1099-C if the creditor forgave more than $600 in debt. If the creditor forgave less, it may still send you a 1099-C – but it isn’t required to. Regardless of whether you receive a 1099-C from your creditor noting the unpaid portion of your settlement balance, you must still include the forgiven amount as income when filing your taxes.
Although exceptions apply in cases of clear tax misconduct, the IRS generally has the right to audit your tax return for three years after you file it. If the IRS discovers that you omitted taxable income, it will require you to pay the missing tax you owe in addition to tax fines for omitting the income. - If you can prove you were insolvent when you settled the debt with the creditor, you can avoid paying taxes on the unpaid balance. You qualify for insolvency if your debts exceed your assets. If you qualify as insolvent, you must compare the amount by which your debts exceed your assets to determine if you can get by without reporting the entire settlement balance or if you are still liable for a portion of the debt. If the forgiven balance is greater than the amount by which your debts exceed your assets, you owe taxes on the difference.
For example, your debts total $50,000 and your assets total $45,000. If your creditor forgave $11,000 of your debt, you are exempt from paying taxes on $5,000 of the debt because $5,000 is the degree to which your debts exceed your assets. You must, however, pay taxes on the remaining $6,000. In the same scenario, if your creditor forgave $3,000, you would not owe taxes on the debt because it is no greater than the amount by which your debts exceed your income. - The IRS treats mortgage debt settlement differently than other forms of debt settlement. When a creditor forgives outstanding mortgage debt you owe after a foreclosure or short sale, the Mortgage Forgiveness Debt Relief Act protects you from the resulting tax liability provided the home in question was your principle residence and the amount forgiven did not exceed $1 million ($2 million for married couples filing jointly). The tax relief available to former homeowners through the Mortgage Forgiveness Debt Relief Act ends in December 2012.