Forgiven a Debt? You May Owe Tax

NEW YORK - MAY 20:  In this photo illustration...
Image by Getty Images via Daylife

No good deed goes unpunished, so the saying goes. That’s certainly true if you manage to get your credit card company or your bank to reduce your balance….The IRS wants its piece of that party…

Until recently, credit cards and mortgage loans were offered like candy to almost anyone. Run up your credit card and no big deal–you could get an equity line of credit [a HELOC], refi your house or with a high FICO score, pass on the debt to a zero interest card. Now, you’ve lost your job or you’ve been forced to go part-time or your spouse has lost a job…Whatever the reason, you need credit now more than ever, but you already have a mountain of debt.

With true hardship, you may be able to talk your credit card company or collection agency into accepting partial payments as full. After all, something is better than nothing, right? Or, you may have determined that if your mortgage company would accept a short payoff and let you keep your home, then you could make it. That’s great, and exactly what you should be doing as a responsible card holder and home owner. Now comes the hard part.

If a credit card company has forgiven some of your debt and accepted say $20,000 of a $50,000 debt as payment in full, then you are going to owe tax on the forgiven amount, here $30,000, to the IRS. If you have gotten your second mortgage holder to reduce your balance from $35,000 to $10,000 which you then pay off in cash, then you are going to have to pay tax on the forgiven $15,000.

That forgiven debt will be added to your yearly income and will, most likely, be taxed at your highest rate or it may propel you into a higher tax bracket. So, plan carefully when you make these deals with credit card companies, collection agencies and mortgage holders. By now, it’s almost June so most of us can pretty well predict what our yearly income will be. If you’ve lost your job and had almost no income, the tax bite will be less. On the other hand, with no job, you’ll have less to spare when tax time rolls around.
How to escape paying the tax?
There is one exception to this taxable debt forgiveness, the Mortgage Debt Relief bill,which was voted by Congress in 2007. Because of this legislation, if you sell your home in a short sale either last year or this year, you will owe no tax, although the bank may have accepted hundreds of thousands less than what you owed. This makes it far more palatable to sell a home in a short sale, this aiding millions of home owners who would otherwise have a foreclosure on their records for the next 7 to 10 years. Note, though, if you negotiate a short payoff of one or more mortgages and remain as owner of the house, you will owe tax.