The basic idea behind debt forgiveness is simple: a person has part of a debt excused and pays the remaining portion to formally satisfy their obligation to a creditor. This works out great for the debtor, who is drowning in bills and is unable to pay back the mortgage, loan or line of credit. What the pardoned individual may not realize, though, is that the forgiven debt comes with tax consequences.
The IRS considers an excused debt as income, which is required to be included on the taxpayer's annual return. This "other income" as designated by the IRS can dramatically increase a person's total earnings. This is especially true in the case of a foreclosure, when an individual may see tens or possibly hundreds of thousands of dollars forgiven at once. This additional revenue, when calculated into a taxpayer's annual income, can create an enormous tax liability.
As with all tax-related issues, the obligation of reporting lies with the taxpayer. Although a creditor will provide a notice to the borrower upon forgiveness of a debt, it is the borrower's responsibility to report the event; failure to do so can come with expensive consequences. Once the IRS assesses that a forgiven amount was not filed and/or paid, notices will be sent out to the taxpayer informing he or she of the balance due.
It's important to understand that whatever information sent to the taxpayer from the creditor is also reported to the IRS. When there's a discrepancy between what the IRS receives from a financial institution and what is included on the return, the taxpayer is held responsible for the difference. In the case of a foreclosure, the bank releasing the property owner from his or her obligation will provide the IRS with a report of the forgiven amount. If the appropriate taxes are not reported and paid by the debtor, he or she will be liable for the resulting tax bill.
When the IRS detects an outstanding liability, the taxpayer is sent a notice of assessment that details the amount due. Assuming the debt total is correct, the individual is urged to move quickly to satisfy the balance. Penalties and interest begin accruing almost instantly, which can rapidly mutate the original amount owed. Repeated non-compliance with IRS notices can lead to aggressive collection efforts, including liens, wage garnishments and bank levies.
Depending on where an individual is in the collection process, resolving the tax debt may be straightforward. On the other hand, if the debt is far beyond what can be paid at once or the IRS is threatening action, it's smart to seek help from a licensed tax professional. Securing a formal resolution with the IRS can be difficult and time consuming; a tax professional can make short work of a tax debt, safeguarding money, property and sanity.