Aug 01, 2020
By Hayley Norton, CPA Manager at Terry Lockridge & Dunn
Having a debt forgiven is usually bad news when it comes to taxes. While you no longer have to worry about repaying the debt, the IRS considers the value of the forgiven debt as income, just like it was cash that somebody gave you.
There are, however, several exceptions to the general rule of debt forgiveness being treated as income:
Gifts. If someone—perhaps a relative or friend—forgives a loan and treats the forgiveness as a gift, you do not owe any tax due to this generosity. Typically, the lender will not owe any gift tax either if the gift does not exceed the annual gift tax exclusion of $15,000 in 2020.
Student loans. Student loans that are forgiven are taxable, but the income you would normally be required to report on your tax return may be avoided by those who provide services in their chosen field of work, such as physicians covered by a public loan forgiveness program. Also, due to a recent tax law change, student loan debt discharged due to a disability is no longer treated as taxable income.
Bankruptcy discharges. A discharge of a debt as part of a court-approved bankruptcy plan does not constitute income, with the amount of money discharged reported on Form 982.
Insolvency. If you are insolvent—you do not have to be in bankruptcy proceedings—you may also get a tax-free pass on loan forgiveness. Insolvency simply means your liabilities exceed your assets. In this case, the difference must exceed the discharged debt amount. For example, if your liabilities are $5,000 more than your assets and a $1,000 debt is discharged, you are in the clear.
Mortgages. You can exclude income from the discharge of debt on your principal residence through December 31, 2020. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. Absent an extension of the current law, mortgage forgiveness will revert to being taxable after December 31, 2020.
What you need to do: Do not get a surprise tax bill! If you think you will have forgiven debt in the near future, please reach out to us to discuss whether your situation qualifies for one of these cancellation-of-debt exceptions.
Contact Hayley at firstname.lastname@example.org or your accountant if you would like to discuss your specific situation. They can be reached at 319-364-2945 in Cedar Rapids, or 319-339-4884 in Iowa City.