Published on: August 5, 2016 Last modified: October 21, 2020

When Can Loan Forgiveness Trigger a Tax Burden?

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    Getting a portion of a loan forgiven requires determination and a lot of time on hold with various customer service representatives. In other cases, a collection firm may just write off the debt after years of collection efforts. Any relief of loan forgiveness might be offset when a 1099-C arrives in the mail.

    The IRS considers cancelled debt to be income. What if you can’t pay a back tax bill that includes penalties and interest? Could your financial hardship allow you to use the Currently Not Collectible or Offer in Compromise programs? This blog will address some of the issues that come up after debt forgiveness.

    Cancellation of Debt Income

    You may wonder how in the world cancellation of debt can be treated as income. If you didn’t have money to pay a debt, how can you pay taxes on the debt cancellation?

    This situation can arise when a creditor gives up on collecting the amount you owe. It may come up as part of the foreclosure process, a mortgage modification or discharge of a portion of your student loans.

    The amount that appears on the 1099-C is the amount of a debt canceled, forgiven or discharged by the creditor. You would need to report this amount in the year the cancellation occurs.

    This is a duplicate form, so the creditor also informs the IRS, which is matched up against what you file. If you forget or don’t include this on your return, the IRS will eventually be in touch. The surprise of owing back taxes along with penalties and interest is never a good one.

    Exceptions to the Rule

    As with everything in the law, there are certain exceptions to the general rule. If a debt is canceled as a gift or as part of an inheritance, there is no need to report the forgiven debt. John Oliver actually did this recently when he purchased uncollected medical bills and forgave the debt as a gift to those who had not been able to pay the debts.

    Some of the Home Affordable Modification Program rules allow you to avoid taxation on the reduction of a mortgage balance. Student loans canceled under certain provisions requiring work for a certain period of time in a certain profession are also exempt.

    If you are hit with a back tax surprise, there are options. Currently Not Collectible status might be an option, but does not provide a complete remedy. An Offer in Compromise can deal with the issues once and for all based on your particular situation. A tax attorney can provide advice and guide you through the process.

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