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The Debt Forgiveness Tax: Paying Money to Save Money

written by: M Lambert•edited by: Laurie Patsalides•updated: 6/8/2009

Many people are so relieved to have a portion of their debt forgiven that they forget to plan for the debt forgiveness tax. The IRS considers debt forgiveness a form of income since you do not have to pay the money back. Learn what you need to do when you file your taxes.

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    Debt Forgiveness Tax

    It is important to be aware of the tax implications of debt forgiveness or debt settlement. The IRS looks at debt forgiveness as income, so it is taxable. The reason for this is, when you borrowed the money you were not taxed on it, and then when you do not pay it back, it is considered a gain. It is important to consider how the debt forgiveness tax will affect you. It may bump you into a higher tax bracket, but you will definitely have to pay more in taxes for that year.

    Your lender will send you a 1099-C for the tax year. You will need to use that to report your debt cancellation to the IRS. When you file your taxes this will increase your income by the amount of the forgiveness. This may bump you up a tax bracket, so you need to be prepared to pay the extra money at the end of the year. You can change your withholdings if you do this earlier on to stop yourself from owing a refund.

    Not all debt that is forgiven is taxable. There are exceptions to the debt forgiveness tax. Loan forgiveness on homes is exempt under certain, specific conditions between 2007 and 2012. Bankruptcy, insolvency (inability to pay your bills), farm loans and non-recourse loans (loans where they can repossess an item) may be exempt. You will need to file Form 982 with your return. Be sure to follow the directions carefully and that you read all the conditions surrounding these exceptions carefully.

    Debt forgiveness can relieve a lot of pressure and worry, and careful planning can prevent it from becoming a burden at tax time. Be sure that you carefully read the guidelines that the IRS provides for debt forgiveness or use a certified accountant to file your taxes that year. Additionally, save money to cover the debt forgiveness tax that you will owe at the end of the year.