If a creditor writes off your debt, or even if you settle that debt with your creditor, the IRS may still count the amount as taxable income.
If you work out a deal to settle with a creditor for any less money than the exact amount that you owe, or if the creditor writes off the debt, the IRS may still regard you as owing money. The IRS will consider the forgiven amount of the debt as income, and you will continue to owe income taxes on it.
How does this work? Creditors will often wait for a pre-determined period of time after a default – one year, for example, or two years – to write off the debt. At this point, the creditor will stop all efforts to collect the debt, declare it as noncollectable, and in order to reduce the tax burden, will declare the uncollected amount to the IRS as what is considered lost income. This same standard is used when debt reductions are negotiated. The amount left unpaid will be reported by the creditor to the IRS also as lost income.
However, the IRS will naturally still want this money taxed, and it will expect the forgiven debtor to pay those taxes. Because the amount of the debt was reduced, and you are no longer expected to pay the forgiven amount, the IRS will treat that amount as gained income, and expect you to pay your income taxes on it.
This standard is also in operation for those debts that you owe after a property repossession or a foreclosure on a house. The law can seem inordinately cruel in these situations. Someone who has lost their home due to foreclosure not only has to suffer through the loss, but will be expected to pay income taxes on an amount of the forced sale. This amount, called the deficiency, is the difference between the amount that was originally owed to the lender, and the amount for which the lender was finally able to sell the property.
However, a 2007 congressional resolution eased this standard for some loans that were forgiven in whole or in part between the years of 2007 and 2012. If the amount of the deficiency arises from the sale of a primary residence (your current home), then the law will offer you some tax relief. These are the rules for when this does or does not apply:
Loans used for a primary residence – if you secured the loan through your primary residence, and used the loan to buy or to improve the house, you will be able to exclude as much as two million dollars of the forgiven debt. You will not have to pay taxes on the amount of the deficiency.
Loans on any other real estate – If a mortgage is secured through any property that is not your own home (like a vacation home, for example), and you default on this, you will continue to owe a tax on the amount of the deficiency.
A default on a loan secured through a primary residence but not used to buy it or to improve it will still leave you owing taxes on a deficiency.
If you find yourself not qualifying for any of the tax exceptions under these standards, there may be other relief available to you. If you can show proof that you were not legally solvent, you will not be held liable for paying taxes.