Forgiven debt equals taxable income

You’ve successfully negotiated a forgiveness of debt with a creditor, saving yourself a lot of money. You feel proud of yourself. You feel that a huge burden has been lifted from your shoulders. But then you begin to feel something creepy sneaking up behind you. It has the potential to make your life miserable all over again. It’s the Internal Revenue Service. The IRS wants a share of the money you saved.

Your creditor tells the IRS

If your debt settlement with the creditor totals $600 or more, the creditor will tell the IRS. In turn, the IRS will notify you that you must report the money you saved through the settlement as income on your federal income tax return. A person with a $5,000 credit card debt who, through a settlement, pays only $3,000 of the debt will realize $2,000 in forgiven debt income, also known as Discharge of Indebtedness (DOI) income, and owe tax on it. You may or may not get word of this new debt in a timely fashion from your creditors. As they often see it, it's not their duty to provide tax advice.

Video: Debt forgiveness may be taxable income

Get tax advice right away

Understanding the federal tax implications of debt forgiveness is your responsibility. Failure to pay tax on DOI income can result in Internal Revenue Service audits, penalties and fines. To avoid an unpleasant surprise at filing time, be careful when selecting a third party to help you. Get solid tax advice before negotiating any settlements. Make certain that you know the exact amount of forgiven debt the creditor will report to the taxman. If you dispute the amount reported, contact the creditor or debt collector right away and ask for a correction.

Cut your liability in three ways

Note that there are three situations in which forgiven debt is not considered taxable income:

Battled contest. If you dispute a credit card charge and win a debt settlement, you can be excluded from the DOI income rule. You will probably not be required to include the amount you saved through the settlement as taxable income.
Insolvency. When your liabilities are higher than your total assets, you are considered insolvent. Up to a point (to be discussed with your tax consultant), you won’t be required to pay taxes on debt reduction or settlement benefits. This exclusion is effective up to the amount by which you are insolvent. If you have had $5,000 in debts forgiven in a settlement and your liabilities now exceed your assets by $2,000, then the $2,000 would be excluded as taxable income. Only the remaining $3,000 would be counted as DOI income and be subject to tax.
Bankruptcy. After you have declared bankruptcy and are making perhaps 10% of the debt payments you once owed, the remaining 90% will be excluded from the DOI rule.

Also remember that new legislation relieves the tax burden when your lender forgives part of the mortgage on your principal residence.

Video: How to Select a Bankruptcy Attorney

Consult a bankruptcy lawyer

Because bankruptcy can be a way to greatly reduce the amount of tax you might have to pay on forgiven debt, an attorney specializing in bankruptcy law can be a good source of information. We have provided a list of leading bankruptcy law firms below. Be sure to ask about all the ramifications of bankruptcy before deciding to go this route.

Bankruptcy attorneys

Cibik & Cataldo
Philadelphia, PA
Phone: 866-745-6190

Clark & Associates
Phoenix, AZ
Phone: 866-682-1372

Clear Bankruptcy
San Francisco , CA (and other cities)
Phone: 866-435-5837

Davis & Jones, P.C.,
Salt Lake City, UT
Phone: 866-632-2707

Diamond, Burt & Akhkashian
Los Angeles, CA
Phone: 866-715-6757

Deborah Kanner Ebner
Chicago, IL
Phone: 312-922-3838

Richard N. Gottlieb
Boston, MA
Phone: 866-305-7236

Kane Russell Coleman & Logan
Dallas, TX
Phone: 866-435-3766

Koffel & Jump
Columbus, OH
Phone: 866-715-6260

Macey & Aleman
Atlanta , GA
Phone: 866-469-0793

Mehlman, Greenblatt & Hare, LLC
Baltimore, MD
Phone: 866-348-2474

Walter Metzen
Detroit, MI
Phone: 888-DEBTGONE

Perla & Associates
Orlando, FL
Phone: 866-309-4389

Vanden Bos & Chapman
Portland, OR
Phone: 866-798-2917

Mark S. Zuckerberg
Indianapolis, IN
Phone: 866-435-3740