What are the Tax and Credit Implications of Debt Forgiveness?

Debt forgiveness has tax and credit implications that can affect the amount of taxes you pay and your ability to borrow in the near future.

If you owe a debt to someone and they cancel or forgive the debt, you may be responsible for paying taxes on the amount forgiven.  The IRS views canceled debt as income.

Whether you owe taxes depends on your individual facts and circumstances. Generally, if you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

According to the IRS, there are some circumstances in which the cancelled debt is not taxed.  Check with a qualified tax professional, but generally the following circumstances are exempt:

  • Discharge of debt on a principal residence
  • Debts discharged through bankruptcy
  • If you are insolvent when the debt is cancelled (You are insolvent when your total debts are more than the fair market value of your total assets)
  • Certain farm debts
  • Non-recourse loans

Debt forgiveness will affect your credit score.  Lenders will report it to the major credit reporting agencies.  It can stay on your credit report for up to seven years, but its impact will start to subside after a few years.

Many don’t realize that banks view foreclosures, deed-in-lieu, and short sales the same way.  In essence lenders view a defaulting homeowner as someone who didn’t honor a contract, regardless of the method.  Fannie Mae and Freddie Mac, the nation’s two largest mortgage investors, generally won’t lend again for five years after a foreclosure, deed-in-lieu, or short sale.

Debt forgiveness should not be taken lightly.  Although it may feel like a huge relief, you must determine all the ways that it affect you, from increased income taxes, a lower credit rating, to your ability to borrow in the near future.