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It’s that time of year again when the IRS audit letters are hitting people’s mailboxes. And one of the most popular letters is reminding folks that they forgot to include their cancelled debt on their income tax returns.
“But why should I have to pay tax on that?” That’s got to be the most common question I hear from folks. “It’s not like the credit card company gave me any money, they just cancelled my debt.”
Let me try to explain it the way the IRS looks at it: If you have a job and you make $30,000 you have to pay income tax on that $30,000 right? Because it’s income to you, you pay income tax. I think that makes sense to everyone (You probably don’t want to pay the tax, but you understand the concept).
When you take out a loan for $30,000, you don’t pay tax on it. The $30,000 is a loan and you are supposed to pay it back, so it doesn’t count as income. That makes sense too.
Now let’s say you take out a loan for $30,000 and you don’t pay it back. We’ll skip past the nasty phone calls from the creditors and go straight to the part where the debt is forgiven. The bank says, “Okay fine, we’re going to write off the debt, you don’t owe us anymore.” Well now that $30,000 isn’t a loan anymore, because you don’t have to pay it back. Once that loan is no longer considered a loan—the IRS counts it as income and you get taxed.
But what if I didn’t take out a loan, what if it was just a credit card? It still gets treated like a loan because essentially, that’s what your credit card does for you. It gives you little loans to buy shoes, or a TV, or groceries. If your credit card debt is forgiven, it gets taxed.
So if I get an IRS letter saying I owe taxes on cancelled debt, do I automatically owe the money? Not always. There are some situations where you might not have to pay the tax, or maybe get the amount reduced. The biggest exclusion is if your home is foreclosed on. If you lived in the house as your main home and you lost it to a bank foreclosure, you can have the principal part of the mortgage that was forgiven be excluded from your income (That can be a pretty hefty tax chunk right there).
Another exclusion is for debt that was discharged in a Chapter 11 bankruptcy. So if you’re in the middle of bankruptcy proceedings, you’re going to want to be sure to claim the bankruptcy exclusion.
The third common exclusion is for “insolvency.” Insolvency means that your liabilities (money you owe) just before the debt was discharged is more than your assets (things of value like cash, stocks, your house, your car, etc.)
There are other exclusions, but these are the three most common ones. If you think that you may qualify for one of these exclusions, then you’ll want to amend your tax return showing that you’ve claimed the exclusion. You’ll put that on a form 982: http://www.irs.gov/pub/irs-pdf/f982.pdf This is one of those cases where I recommend that you have a professional work on the return. There are a lot of little details that go into the exclusion of debt that just won’t fit into a short blog like this. If you’re pretty handy with tax issues, the details can be found in IRS publication 4681: http://www.irs.gov/publications/p4681/index.html