Are There Tax Consequences If A Creditor Forgives Or Discharges My Debt?

  • introI have a credit card and I have negotiated with the credit card company to have the balance reduced. Are there any tax consequences?

  • I am filing for bankruptcy and my debts will be discharged. Will there be tax consequences on the discharge of debt if ordered by the bankruptcy court?


Yes, there may be tax consequences based on the situation.

For example, typically the IRS’s position is that when a person’s debt by a creditor is reduced or completely cancelled, that person’s net worth increases by the same amount.  This “increase in net worth” due to the cancellation of debt is treated as income to the person and that income is subject to Federal and state income taxes.

There are exceptions to this rule.  Cancellation of debt is not income to the person when:

  1. A person’s debts are discharged through bankruptcy,

  2. A person is insolvent when his debt is cancelled; or,

  3. A person has a non-recourse loan in which the lender can only repossess the property and cannot sue the person.

The biggest exception is the Mortgage Forgiveness Debt Act of 2007. A person is allowed to exclude from his taxable income either

1) the amount of mortgage debt which is owed but which is discharged as a result of a foreclosure proceeding,

or 2) the amount of mortgage debt which is reduced through a mortgage restructuring.

Both of which must have taken place in calendar years 2007 -2015.

 

However, this exception only applies if the forgiveness of mortgage debt directly relates to either

1) a decline in the home’s value,

or 2) the taxpayer’s financial condition.

The Mortgage Forgiveness Debt Act of 2007 is set to expire on December 31, 2016.

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*Under Internal Revenue Code 108, the reduction or cancellation of a person’s debt by a creditor increases that person’s net worth and it is treated as income subject to income taxes.  Situations in which a cancellation of debt is not income are as follows:  debts discharged through bankruptcy; a taxpayer is insolvent when a debt is cancelled; or, a non-recourse loan in which a lender can only repossess the property and cannot sue the creditor.

 

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