Seeking Forgiveness Of Debt? 3 Steps To Avoid A Tax Bill

Do you expect to have a portion of your debt forgiven by the lender? Debt relief through this means can be a valuable financial tool and can remove a burden from you. But it can also bring tax consequences that you need to be aware of. How can you ensure you get the relief you deserve while avoiding any tax surprises? Here are three key steps to take. 

1. Research Taxability Before Accepting

In general, debt forgiven by a lender should be considered as potentially taxable income. When you start from the understanding that you may face a tax bill for the forgiveness, you can then make an informed decision.

The time to research tax consequences is before you accept the forgiveness offer so you retain more options. For example, you may find that it's better to file bankruptcy rather than to negotiate with your credit card companies now. Why? Debt discharged in bankruptcy is one of the primary forms of nontaxable debt relief. If you would face a burdensome tax bill for forgiven debt, bankruptcy may be a better option. 

2. Learn About IRS Exceptions

If the debt would normally be considered taxable income, some options exist that may turn it into a nontaxable event. Learn about these to see if they may apply to you and what you must do to qualify for them. 

One of the biggest tax exceptions is insolvency. If a taxpayer's debts are greater than their assets as a whole, they are considered insolvent by the IRS. Some or all of the forgiven amounts, then, wouldn't be taxable. 

Other options that affect fewer debtors include if the forgiveness was a gift (e.g. from a grandparent who loaned you money), was part of a student loan forgiveness program, was due to temporary laws enacted for targeted debts (often for mortgages) during bad economic conditions, or was because of certain farm exclusions.

Each exception has its own rules that you will need to learn in order to abide by and show proof for. So you might need a letter from your grandparent marking the gifted debt forgiveness as "paid in full." You would also need to complete calculations to claim insolvency per IRS standards. 

3. Work With a Tax Preparation Service

The best resource to help determine the tax consequences of your type of forgiven debt is an experienced tax preparation service in your state. They can help you find even the more esoteric exceptions, like a business debt that would have been a deductible business expense. Then, they will work with you to follow the rules needed to qualify, including completing IRS worksheets to calculate insolvency. 

Make an appointment today to learn more about taxes and debt relief. The time you invest now will pay off when you avoid an unnecessary tax bill in the new year. 

To learn more, contact a tax service.