Forgiven debt may impact your 2013 tax bill

Many studies show that most Americans were in a considerably better financial position in 2012, due in large part to stricter money management and gains in the housing market. However, this was not the case for all individuals and some entered into debt forgiveness agreements to lower their credit card and mortgage balances. While debt forgiveness may have undoubtedly made it easier for them to get back on track and make ends meet, many may be surprised to find a tax bill from Uncle Sam in April.

When lenders agree to forgive or cancel credit card and some mortgage debt, the Internal Revenue Service considers the amounts to be taxable income. In 2012, the IRS sent out an estimated 6.4 million 1099-C Cancellation of Debt forms, up from 3.9 million sent out in 2010, according to USA Today. Therefore, consumers who entered into a debt forgiveness agreement in 2012 should consult their tax preparer to gauge how the IRS may calculate their liability.

Not all forgiven debt is taxable

Although many types of forgiven balances may result in a tax bill, there are several exceptions. For example, debt that is discharged through bankruptcy protection is not taxable by the IRS. Those who receive Form 1099-C for debts discharged through bankruptcy should contact their tax office and fill out Form 982 and file it with their return.

In addition to bankruptcy protection, taxpayers who are considered insolvent at the time their debt was forgiven may also not be taxed on some or all of the cancelled amount. Individuals are considered insolvent if their debts exceeded their assets during the forgiveness phase. This exclusion is also reported on Form 982. Farmers may also find that they will not be liable for all or a portion of their forgiven debt if they meet certain criteria. Those who incurred debt directly from the operation of a farm, earned more than half of their income in the past three years from farming and owed the loan to a person or agency regularly engaged in lending will generally find that their forgiven debt is not considered taxable.

Lastly, non-recourse loans that are forgiven are typically not taxable. A non-recourse loan is one in which the lender's only recourse to recoup their losses is to repossess the property or take legal action against borrowers. For example, homeowners who lose their property to foreclosure will typically not be taxed on their losses.

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