What are the tax consequences of debt forgiveness?
Give us this day our daily bread,
and forgive us our debts,
as we also have forgiven our debtors.
Now, before you go ahead and forgive all your debtors, you may want to think about the context of what this Gospel verse is trying to say. Is Jesus telling you to really forgive your actual debtors of actual money? Really? People who actually owe you money? Or rather, is the word “debtor” more of a metaphor, meaning the people who may have wronged you?
The reason I mention it is – it may not be the best Christian thing to do – to forgive your debtors. As in — you may not be doing them any favors.
You see, if someone owes you money, and you figure — hey, it’s just not worth it to try collect on the debt, the general rule is you can “write off” the bad debt and take it as a deduction.
However, for whatever you “write off” the IRS is going to claim is income to someone else. When you wish to cancel debt over $600, chances are you will need to prepare a form 1099-C and send it to the person whose debt you are forgiving or cancelling.
Now for the person who received the Form 1099-C Cancellation of Debt, they may or may not have to report it in their gross income — making it taxable. So the act of debt forgiveness may in fact come back and harm the person with a tax bill from the IRS.
So is debt forgiveness taxable?
The test comes from form 26 USC 108:
(a)(1) Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(A) The discharge occurs in a title 11 case,
(B) The discharge occurs when the taxpayer is insolvent,
(C) The indebtedness discharged is qualified farm indebtedness,
(D) In the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
(E) The indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2014.
The most common type of cancellation of debt income we deal with
I was on the Stan Simpson show earlier this year to talk about type “(B)”, the discharge of debt when a taxpayer is insolvent. See, and this is very important — IT MAY NOT BE TAXED — depending on whether the taxpayer is “insolvent” or not. This happens a lot when people negotiate credit card debts.
The test for insolvency is as follows:
You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include: The entire amount of recourse debts, The amount of non-recourse debt that is not in excess of the FMV of the property that is security for the debt, and The amount of non-recourse debt in excess of the FMV of the property subject to the non-recourse debt to the extent non-recourse debt in excess of the FMV of the property subject to the debt is forgiven.
The IRS has a worksheet to determine insolvency at the end of Publication 4681
What you need to know about Cancellation of Debt, 26 USC 108 and IRS Form 1099-C
- For debt-holders: Well I suppose, if you wanted to be super-Christian, you could cancel a debt and not deduct it from your own income. Relieving you of a responsibly of filing a Form 1099-C against your debtor. But then you would be paying taxes on money you never saw. So let’s think about that before we do anything rash.
- For debtors: If you do ever receive a Form 1099-C, be sure you mention it on your return, or else the IRS will think it is income. But if you do mention it on your return, you very well may be able to exclude it from your income if you meet one of the conditions of 26 USC 108 (a)(1).