If a creditor cancels a debt, the IRS requires them to report the discharged amount and issue a 1099-C. The forgiven debt effectively becomes taxable income. There are a limited number of exclusions to this rule. This requirement kicks in for an amount of $600 or above.
At its most basic, a debt is a contract. The benefit to the borrower is a purchased item or lump sum of money. The consideration to the lender is a stream of payments under specific conditions, including an interest rate.
When the debt is canceled, the borrower still has the benefit while the lender has lost the consideration. In effect, the borrower received free stuff, which makes the amount of free stuff an equivalent of income.
This even applies to secured loans, such as a vehicle. Imagine that a vehicle with a $15,000 loan balance is repossessed. The dealer sells the vehicle for $10,000 and forgives $5,000. The borrower will have $5,000 in taxable income since that amount is wiped away.
A limited exception applies to mortgage holders covered by the Mortgage Forgiveness Debt Relief Act, which applies to tax years 2007 to 2017. It possibly applies to 2018, if the forgiveness agreement was entered into in 2017. Under this act, up to $1 million in mortgage forgiveness may be excluded from taxable income for single filers and up to $2 million for married filing jointly filers.
A more general exclusion may be granted by the IRS for individuals who can prove they were insolvent at the time of discharge. Filing bankruptcy under Chapter 7 or Chapter 13 is the most certain way to demonstrate this insolvency, but a general case also is built. The IRS has significant latitude in accepting or rejecting an insolvency exclusion outside of bankruptcy so a detailed and specific case will need to be developed.
While discharged debt is a net benefit to stressed borrowers, there may be an unavoidable cost that comes with it. If you would like a consultation about how you may qualify for exclusion from this surprising income, please contact us or visit us at http://www.robertstaxadvisory.com/.