When you slide into a pit of debt, it can feel like you might never climb out. In some cases, though, your creditors will waive a portion or perhaps even all of your debt; this is known as debt forgiveness. And while this might seem like the ideal answer to your financial woes, there are tax strings that come attached to your fortuitous arrangement.
If you're thinking about making a deal with your credit card company or mortgage lender, make sure you have a clear understanding of the end result. Although you might reduce your monthly stress to a manageable level, this may prove to be only temporary. As your credit obligations are diminished, you'll be presented with an unwanted add-on to your tax bill.
Why You're Taxed
If your credit debt is reduced you are, in effect, realizing a financial gain. You are no longer obligated to pay your creditor back for goods or services for which you have already taken possession. Because these items have a monetary value and you're the beneficiary, you may think of this as a form of profit.
As with any other type of income, the IRS requires you to pay the associated tax. In the case of forgiven debt, your lender will report the reduction to the federal government and provide you with a duplicate transactional detail; you'll receive this as a 1099. When you prepare your tax return, you're required to include the amount of debt that was expunged, calculate the taxable event and pay any liability. Failure to do so can create less-than-desirable complications with the IRS.
From Forgiven Debt to Tax Debt
While you likely do your utmost to be truthful and transparent in your tax filing duties, it can be easy to overlook something you're not used to reporting. Before you move into the next tax season, ask yourself if you've had some form of debt credited or forgiven. You will probably recall handling such an issue, but it doesn't hurt to check the current history of every open line of credit.
You should also be wary of notices of forgiven debt when you don't have a record of such an event. For instance, you may be only in the process of negotiating an adjustment to a delinquent mortgage when you receive notice that a modification has been completed. Additionally, your creditor might even inform the IRS of the reduction. But creditors aren't infallible. If you have any question about the validity of an abated debt, double-check with the lender in question. Otherwise, you may be on the hook for a taxable responsibility that hasn't yet been created.
If you do have a legitimate forgiven debt, make sure to report it on your tax return. The IRS will detect the discrepancy between what you and your creditor reported, determine the liability, and send you a bill for the difference. If this assessment occurs after the filing deadline, you'll also have penalties and interest attached to your newly formed tax debt.
Tackling Tax Delinquency
In the event that your debt simply changes hands from your creditor to Uncle Sam, don't despair. You can seek a resolution for your tax issue, though you may not want to tackle it alone. A licensed tax professional can consult on how best to handle the issue and, if necessary, provide a solution before it gets out of control. Like any other collection agency, the IRS assesses additional fees the longer you wait to handle the debt.
As opposed to the average collector, though, the IRS has powerful tools at their disposal. Should you decide to disregard your tax delinquency, you leave yourself vulnerable to actions such as a wage or bank levy. Given the volatile nature of IRS collection tactics, you might want to tap the shoulder of a licensed tax professional. He or she can help prevent that forgiven debt from turning into a tax nightmare.