There is an importance difference between cancelled debt, discharged debt and charged off debt. Depending on which debt you have, you may be liable for paying tax on them come April. Let’s start with cancelled debt.
Cancelled Debt is the portion of debt that you owe a creditor. When a creditor is unable to collect the debt from you they may cancel it or write it off. When the debt is cancelled or written off, you are no longer liable to repay the debt. You may still be liable for paying taxes on that cancelled debt.
How can that be?
For example let’s say you took out a loan of $3000. You have paid off $1000 but due to financial circumstances you can no longer make the payments. After several attempts to collect, the creditor decides to cancel the debt. In essence, the $2000 that you did not pay off from the original loan is considered your income gain. It is money you gained and for tax purposes is an increase in your income because you basically got $2000 for nothing.
If the creditor cancels your debt they may, but not always report this to the IRS. You are liable to pay taxes if the debt cancelled exceeds $600.
A creditor that cancels debt over $600 is required to report this to the IRS using Form 1099-C. You in return will be required to report this on your tax return as income using the 1099-C Form. Even if you do not receive a 1099-C from the creditor it does not necessarily mean that they did not file the 1099-C with the IRS. If you do not list the cancelled debt as income and the creditor did file the form you could end up with a tax bill or even an audit.
Cancelled debt is not always taxable. One of the exceptions is filing for bankruptcy: Debts discharged in bankruptcy is not considered to be taxable income. There are other exceptions discussed in the IRS publication 4681. Sometimes, mortgage debt is cancelled. The Mortgage Forgiveness Debt Relief Act and Debt Cancellation might be applicable and avoid a tax debt on a cancelled mortgage. The Act allows to omit income realized cancelled debt in the course of loan modifications or foreclosure on your principal residence. For more information about tax consequences please consult your tax consultant. The Act is widely misunderstood by real estate agents who often tell people that deficiencies on foreclosed properties are forgiven and not collectible. That is a different situation. In many states deficiencies can be pursued by the mortgage company. In Illinois and Missouri we see even first and second mortgage holders sue clients for deficiencies. Filing bankruptcy might eliminate the obligation to pay any deficiency on a foreclosed home.
Discharged Debt is debt that is discharged, or wiped out through completing a bankruptcy. When you have discharged debt and tax season rolls around you can file Form 982. This form excludes you from paying taxes on the amount of debt that was discharged during bankruptcy.
Charged off debt is debt that a creditor removes from their books and either tries to collect through in house operations or by selling the debt off to another debt buyer. Creditors report this debt as charged off so that they can receive a tax exemption from the government. This usually occurs when there has been no payment on debt for over 180 days. You are still liable for repayment of charged off debt. Charged off debt is reported to the credit bureaus and shows to other creditors that you are likely to not complete repayment making it difficult to secure future credit.
In the end there really are two certainties in life, death and taxes. The way you deal with your debt can affect the amount you pay in taxes. In order to not be liable for taxes on debt you owe, the best bet is to file bankruptcy.