Forgiveness of Debt

This can be a thorny and surprisingly upsetting area. Whether it’s called forgiveness of debt, or cancellation of debt, or other words to that effect, the concept here is that you owed somebody or something money, and then part or all of that was forgiven or waived. A common example is credit card debt. For instance, you ran up charges of $50,000 on your credit card, ran into some problems and worked out a deal with the credit card company where they would take $10,000 and walk away. 

What happened from a financial, as well as tax, point of view, is that you just got a $40,000 cancellation (forgiveness) of debt. What is going to happen almost assuredly is that you will get a 1099C from that credit card company, in effect putting you on notice that they have advised the IRS you got $40,000 of forgiveness of debt income. Yes – that is taxable to you. 

Now there is a good news/bad news angle on this forgiveness of debt problem. The good news is, there is an exception where you won’t be taxed on any/part of that $40,000. The bad news is that you have to be pretty much broke to be able to benefit from this exception. The way this works, to oversimplify, is that if you had a negative net worth (liabilities exceed assets) before the forgiveness of this debt; and you still had a negative net worth after the forgiveness of debt – then, here’s an opportunity to smile, you have no taxable income from this $40,000 forgiveness of debt. It’s really kind of that simple – you have to be worth nothing, and you can get away with it. By the way, there are some special less onerous rules when it comes to the forgiveness of debt on your home, your principal residence.