Last-minute tax surprises: four ways to avoid taxes on forgiven debt

When a taxpayer has debt forgiven – whether from a credit card, mortgage, student loan or some other debt – it may seem like they can finally close the door on that financial obligation. But then they receive a 1099-C from the lender – a form that also went to the IRS – reporting the amount of the forgiven debt. And in most cases, taxpayers will need to include the forgiven debt in their income on their tax return, unless they qualify for a tax exclusion.

Mortgage debt forgiveness tax exclusion

The first major exclusion is for certain foreclosures. First enacted in 2007 after the housing crisis, the mortgage debt forgiveness exclusion provides substantial tax relief for families whose principal residence has been foreclosed. It protected taxpayers from the taxation of at least $5.1 billion in 2014. Homeowners affected by foreclosure or mortgage restructuring excluded $94,210 on average in forgiven mortgage debt from their taxable income in 2014.

To qualify for this exclusion, the home must be the taxpayer’s primary home. If it is, and if the discharge of debt is related to a decline in the value of the property or the taxpayer’s financial situation, the taxpayer may exclude up to $2 million of forgiven debt from their income. If they are married filing separately, they can exclude $1 million.

Because this exclusion expired at the end of 2016, it is generally not available for taxpayers who have mortgage debt forgiven in 2017. In these cases, taxpayers should see if they can qualify for a different exclusion.

Debt canceled during insolvency

If a taxpayer can demonstrate insolvency immediately before their debt was forgiven, they can exclude it from their income. To be insolvent, the taxpayer’s debts must exceed the value of their assets. The insolvency worksheet the IRS provides includes 13 types of debt including credit card debt, mortgages, auto loans, medical bills, student loans. Assets include more than just the value of cash on hand and bank account balances. Taxpayers must also account for assets like real estate, cars, computers, furniture, tools, jewelry, clothing and books, to name just a few.

Debt canceled in a Title 11 bankruptcy case

Taxpayers may be able to exclude debt forgiven in a Title 11 bankruptcy, including any of its chapters, from taxation. For the exclusion to apply, the taxpayer’s debt must be discharged by the bankruptcy court. Debt forgiven outside of the bankruptcy process does not qualify for the exclusion.

Other tax exclusions for farms and businesses

Other exclusions for farms and businesses could apply. The farm exclusion is for debt incurred in the trade or business of farming. The lender must be in the business of lending and cannot be a relative, somebody who sold the property or who earns a fee from the farm.

Complex qualifications for the business exclusion for real property limits the exclusion to debt used to buy, build, or improve depreciable real property used in the taxpayer’s trade or business. In some situations, the exclusion functions more like an income deferral mechanism and less like a true income exclusion due to basis reduction requirements.

Qualifying for a tax exclusion requires paperwork

Taxpayers who qualify for one of the exclusions can’t just leave the information from their 1099 off their tax return. Instead, they must file form 982 with their tax return. If they don’t qualify for an exclusion, they must include the forgiven debt from the 1099-C on line 21 of form 1040.

Everybody wants to get the most money back when they file their tax return and that is especially important for taxpayers with cancelled debt. Figuring out the exclusions may be complex, but finding one that they qualify for will help them start rebuilding their financial situation.

If a taxpayer doesn’t qualify for an exclusion, it is still important for them to include the forgiven debt on their tax return. Because the IRS also receives the 1099-C, the surest way to get audited is to leave that income off the return. Reporting the income accurately will help them avoid a potential audit and resulting interest and penalties. In the long run, this is also the best way to rebuild their financial life.