The Internal Revenue Service (IRS) can consider a loan that has been written off or settled by your creditors as a taxable income. In other words, you are liable to pay taxes on the forgiven debt amount you owed to your creditors.

How forgiven debts are justified as taxable income

Generally, creditors write off debts after a certain period of time, say for instance, one, two or three years after you’ve defaulted on your loans. It is the creditors who then would stop all sorts of collection activities to get back their loan money, declare them as uncollectible and report about the same as lost income to the IRS. This the creditors do to minimize their tax burden.

The same would hold true in case you’ve settled your debts or have negotiated for debt reduction with your creditors. Here too, the creditor would report the forgiven debt amount to the IRS as part of its yearly loss of income.

However, the IRS will come back to haunt you and ask you to pay up for the forgiven debt. This is simply because you’re no longer liable to repay the debt in full and this gets translated into a kind of gained income, for which the IRS will hold you liable to be included in your annual tax return.

Debt forgiveness – IRS Reporting

Any particular creditor or financial institution that has forgiven or written off principal debt amount of $600 or above (excluding the fees or interests) will have to send the Form 1099-C both to you as well as the IRS by the end of that tax year. The purpose of these forms are to report income and so, when you file your annual tax return papers, then the IRS will verify whether or not you’ve mentioned the amount of settled or written off debt on them through the Form 1099-C and whether or not you’ve paid your taxes accordingly.

However, if you don’t receive the Form 1099-C from your creditors, then they may have at least sent that to the IRS. So, if you don’t list that forgiven debt amount as part of your yearly income and your creditors have submitted the Form 1099-C to the IRS, then you could be served with a tax bill or worse a tax audit notice. Thus, you could end up wasting quite a lot of money both on IRS interests and penalties by the time your tax issues are resolved.

IRS Reporting – Events that allows a waiver

The IRS follows some reporting exceptions mentioned in the Internal Revenue Code (IRC). Take for instance, if one of your creditors have issued and submitted the Form 1099-C to the IRS, then your liability to report the same on your annual tax return may be waived, provided:

the written off or settled debt was a nonbusiness debt and that the same was cancelled prior to 2007, due to Hurricane Katrina the cancelled debt obligation was a tax deductible one, if you had made the payments an education loan was written off since you worked under an employer as per the agreement you signed at the time of taking that out you were discharged of your debts under bankruptcy your debt was cancelled or written off as a gift (though such an act would be an unusual one) or, you broke your bank before your debts were cancelled or written off by the creditors.

The term ‘insolvency’ here implies that your outstanding financial obligations exceeded the value of the assets you own. Therefore, to find out whether or not you’re insolvent, you need to add up all your assets as well as your debts and that includes the debt that was either cancelled or written off.