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WHY IS DEBT CANCELLATION OR FORGIVENESS GENERALLY TAXABLE?

The Internal Revenue Service (IRS) generally treats cancellation or forgiveness of indebtedness as income. But why? Because to do otherwise enables persons to defraud the IRS.

How could the IRS be defrauded? Let me illustrate by the following example:

A person wants to be paid for his services without it looking like income. So he claims he borrowed the money (because a loan is not income), and then the so-called “lender” (in reality the client/customer) would simply write off the “loan”.

To avoid this fraudulent scheme, tax law generally treats cancellation or forgiveness of debt as income.

But there are exceptions to the above rule. For example, the following types of debt forgiveness or cancellation are typically non-taxable events:

1. Bankruptcy discharge of debt by bankruptcy;

2. Insolvency (your liabilities are greater than the value of your assets); and

3. Cancellation of certain qualifying loan debts related to buying, building or substantially improving qualified principal residence indebtedness.

Thus, if you have received an IRS Form 1099-C from a creditor, then, depending on your circumstances, you need, to file IRS Form 982. The filing of Form 982 will be used to show the IRS that the debt cancellation or forgiveness is not taxable.

Tax laws are complicated. This article is not tax or legal advice. To determine whether or not and how the above tax laws apply to your particular situation, you are urged to seek counsel from an experienced and knowledgeable tax professional.

Moreover, be proactive. Before going forward with a short sale, bankruptcy, or debt settlement, seek advice from your tax adviser to determine what, if any, tax consequences there may be.

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