In this video, you get answers to these questions:
- What is the cancellation of debt income when debt is forgiven?
- How does the IRS consider this debt?
- What are the exceptions?
- When is the money not subject to income tax?
- What are some examples?
Introduction
Many people who are unable to pay their credit card bill naturally seek a balance reduction from the credit card company or the collection agency. Sometimes the balance is reduced, and the account holder is happy. However, they may have unknowingly made a serious mistake.
The IRS generally considers forgiven debt, or debt settled for less than the full amount owed, to be “cancelled.” Cancelled debt is generally treated as income that must be included on the filer’s tax return. Accordingly, the card holder may have reduced the amount he or she owes to the credit card company, but they increased the amount owed to the government. Of course, the amount of cancelled debt will be greater than income tax on the cancelled debt which results in a net positive. However, a problem arises when: 1) the individual is a candidate for bankruptcy; and/or, 2) the individual fails to realize that they qualify for an exemption or exclusion from taxation on their cancelled debt.
Bankruptcy
It is not uncommon for debtors to settle a few unsecured debts prior to realizing that, given their circumstances, filing bankruptcy is an optimal approach. In doing so, they likely incur income tax on cancelled debt. Unsecured debt is generally dischargeable in bankruptcy meaning the debt is no longer owed. Tax debt is generally non-dischargeable in bankruptcy unless a number of factors are present (primarily involving the age of the tax debt).
In other words, in many instances the debtor unknowingly converted dischargeable unsecured debt (which would not be taxed as a result of the discharge) into non-dischargeable priority tax debt.
Exceptions and Exclusions to Income on Cancelled Debt
Additionally, there are a number of exceptions and exclusions to the general rule that cancelled debt will be treated as income. The IRS describes the exceptions and exclusions in detail here: http://www.irs.gov/pub/irs-pdf/p4681.pdf.
One exception commonly applicable to people who cannot pay their credit card debt is the insolvency exception. As explained by the IRS in the above link:
[d]o not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the [Fair Market Value] of all of your assets immediately before the cancellation.
Many people overlook this exception when filing their taxes and thereby pay too much in taxes or incur unnecessary tax debt which, again, is difficult to discharge in bankruptcy.
Those who have committed this error should contact a qualified attorney who can advise them on how to rectify the situation.
Video Transcript
What is cancellation of debt income when debt is forgiven? That’s the question I’m going to answer today.
I’m Aaron Hall, a business attorney in Minnesota. You can learn more about me at aaronhall.com, and this video is subject to the disclaimer, which is linked in the description below.
All right, cancellation of debt income. What is it? Well, imagine that you have a credit card and you have spent $50,000 on that credit card. Maybe you took a trip and you put the airline ticks on tickets on it. Maybe you bought some products, whatever it is, you spent $50,000 on that credit card. Well, time goes by and you can’t pay that bill and the credit card company comes calling, collection agency gets involved and at the end of the day, because you have no money and you can’t pay that bill. The only way you can do it is if you borrow some money from your parents. And so let’s say you do a deal where you’re going to borrow $5,000 from your parents, and you have offered to pay $5,000 cash and the credit card company in exchange will wipe out $45,000 of debt. So ultimately you’ve paid off $50,000 with a $5,000
payment.
Seems like a great deal, but here’s a catch that everybody in this situation should know about. The IRS considers this cancellation of debt income, which is subject to income tax on your tax return each year. This $45,000 of debt that was forgiven is considered income to you. Here’s why. It helps to understand
the background behind this.
You got $50,000 worth of value when using a credit card. You only paid 5,000 for it when you eventually paid that credit card bill. So of 50,000 you paid for, which meant you got $45,000 of value without paying for it. You got $45,000 of wealth, $45,000 worth of goods or services. That is subject to income tax. Now, there are some exceptions. Let’s talk about those. When is that money not subject to income tax? Well, for one, bankruptcy. If you file for federal bankruptcy, you don’t have to pay income tax on debt that was forgiven.
There are a couple of other examples though. Let’s say that you are being forgiven debt, but there is a dispute over how much debt it actually is. In that case, there may not be $45,000 worth of debt forgiven. Perhaps there’s only $5,000 worth of debt forgiven and you’re disputing the rest. Well, that’s a difficult situation because did you get $45,000 worth of debt cancellation or $5,000 worth of debt cancellation?
These are issues for an attorney or a CPA to work through, but this is an important consideration because that will have a significant impact on your income tax bill when you file your tax returns at the end of the year.
There’s also a situation where you might have claims against the other party. So unlike the credit card scenario, let’s say two business owners are fighting and one says, “Hey you, I’m going to relieve you of $100,000 worth of debt, but you have to agree not to sue me for copyright infringement.” Well that is a mutual release of claims, and in that case you may not actually have cancellation of debt income because there were claims forgiven or canceled on both ends. So how you characterize a settlement agreement is so important.
We’ve just touched on the issues here so you can spot them to address with your attorney or CPA. But the bottom line is to keep in mind that if debt is forgiven or canceled, there very likely is an issue of having an income tax liability on your tax return at the end of the year. To learn more, see the description below which links to an article I wrote at aaronhall.com, and if you’d like similar videos like this in the future, you can subscribe to this channel or subscribe to our email list. All of this video is subject to the disclaimer in the description below. I’m Aaron Hall, an attorney representing business owners in Minneapolis, Minnesota. Thanks for joining me here today.