If the economy has hit you and your wallet in recent years you may have reached out to your creditors and asked for forgiveness or reached a settlement on a portion or all of your debt. Be careful! That debt settlement may be taxable to you as income...

The IRS recognizes forgiven debt as income even if you have foreclosed on your home. It’s pretty brutal to think about a family that may have gone several months with reduced income due to a lost job or reduced hours. That leads to collection phone calls and all the stress that comes with it and eventually, the family loses the home to foreclosure...... then you get a tax bill!

Now the good news, only a portion of it is taxable. For instance, if you owe $250,000 and the bank sells the home for $100,000 then you only owe tax on the $150,000.

Congress, in 2007, did enact legislation that excludes up to $2 million in forgiven mortgage debt from taxes as long as the mortgage was for a primary residence. The exclusion is set to expire at the end of 2012. So, if you are going to lose your home to foreclosure—lose it before December 31, 2012.

To qualify for the exclusion you may need to notify the IRS that your forgiven debt was a foreclosure and may qualify for this exclusion.

Other forgiven debts that could be considered income include credit cards, student loans, and mortgages on investment properties. Also, if you have a second mortgage or home equity line of credit on your primary residence that was not used to improve or purchase your home then it will not be included in the exclusion. So, your vacation or your new business will keep your forgiven loan from being included in the loophole.

Although, I feel that if you have borrowed money then you owe it and you should do everything possible to make sure your creditor is repaid. You do have some options when it comes to the taxes and your debts.

Bankruptcy is an option and should be avoided at all costs, but in the event you do file your debt isn’t taxable as part of a bankruptcy proceeding. Also, if you can prove insolvency then you should be safe from the IRS.

Please consult with your local tax professional at Liberty Tax® for assistance with your situation.

-david rocci

Disclaimer: Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.