The prospect of a creditor forgiving a portion of debt may seem like cause for celebration for the debtor. Unfortunately, the IRS may also celebrate.
Such forms of relief are viewed by the IRS as extra income to the debtor. As a result, tax consequences often apply. Most commonly, the IRS deals with debt relief tied to credit card debt cancellation and mortgage modifications.
Credit Card Debt
If a credit card carrier accumulates a large amount of debt, a credit card company may be willing to negotiate accepting a lower payment to settle the entire debt. Unfortunately, tax consequences often attach to this form of debt cancellation.
The forgiven balance is considered "dry income" by tax professionals. It is reported to the IRS by the credit card company and a 1099-C form is sent to the forgiven debtor. The cancelled credit card debt is considered income, and thus subject to the debtor's income tax rate.
Generally, mortgage deficiency forgiveness does not result in tax consequences. The IRS, under The Mortgage Forgiveness Debt Relief Act of 2007, allows exclusion of up to two million dollars of debt forgiveness on a principal residence. This applies to relief from both restructuring a mortgage and foreclosure.
Discharging debt is often an issue with second mortgages. The issue frequently arises when the owner owes more on the second mortgage then the home is worth, and the bank or loan servicer typically writes off the debt. As long as the mortgage was "used to buy, build or substantially improve your principal residence and be secured by the residence," it falls within the qualified principal residence indebtedness tax exclusion.
Debt forgiven from rental property or second homes does not qualify under this provision. However, relief under insolvency provisions may apply.
Weaving through the maze of various tax exclusions and exceptions is difficult, but the guidance of an experienced debt solutions attorney can help you determine the most beneficial path to financial recovery.