Funds received as proceeds of a loan aren’t taxable as long as you’re expected to pay it back. However, the moment some or all of the debt is forgiven (and doesn’t need to be paid back), the IRS will jump in and want its cut.
Don’t be caught off-guard by unexpected income taxes when this happens. Instead, keep these tips in mind:
- An indication of a canceled debt larger than $600 would be the arrival of Form 1099-C. The IRS also receives a copy of this form. If you disagree with what the form states, it’s important to work with the lender to correct it.
- Sometimes the IRS won’t wait for a cancellation of debt (COD) to determine your loan is actually taxable. This can happen when a loan resembles a tax-sheltered sale as was this $13.5 million tax case, for example.
- Loans between family members are tricky. The loan needs to be genuine and not below market rate or pay-back-when-you-can. Such a loan will likely be viewed by the IRS as a taxable gift whether it’s forgiven or not. If this is the case, the only way to truly avoid taxation is for the gift to remain under the current $15,000 ($30,000 for couples) annual threshold for the gift tax exemption.
- Exclusions can be made for CODs that involve the taxpayer’s main home or mortgage, particularly those who had their mortgage debt canceled in 2016.
- Other exclusions might apply to second homes, rental or business property, credit card debt, or car loans.
- Lastly, if the taxpayer is insolvent both before and after the forgiveness, then the debt will not be taxable.
Whichever side of the loan you’re on, talk to a tax advisor first to consider the tax implications of reducing or forgiving the debt. Walk into a COD unprepared and your “forgiveness” may be met with a surprising bill from Uncle Sam.