All debtors are required to pay back what they owe. And in order not to run at losses, creditors usually go the extra mile to ensure that you pay back every dime of your debt, even if it means selling it. However, sometimes, you can get lucky. A creditor can relive you from a debt obligation, meaning that you aren’t obliged to payback what you owe. Under tax law, benefitting from a discharged debt is deemed an income. Given that a discharged debt is concerned as an income, if a creditor relieves you from a debt obligation, are you required to pay cancellation of debt income?
If your debt was cancelled, forgiven, or discharged for less than what you owe, you are required to report the development in your tax return for the year the cancellation occur. However, the cancelled debt isn’t taxable if the law allows you to exclude it from your gross income.
Having multiple unpaid debts and a lorry load of bills to pay can be a hassle. In fact, if you aren’t careful, a single debt can ruin your finances. Which is why I always advice individuals who struggle to pay their debt to bring their creditors to the negotiation table. If you are lucky, your creditor, out of the kindness of his heart, will relieve you of your debt. But if you aren’t, you can always pat yourself at the back and seek another solution. According to the law, cancellation of debt is an income. But, does this mean you are to pay tax on it? Read on to find out.
How to Remove Settled Debt From Credit Report?
Is Cancellation of Debt Income Taxable?
Paying a debt can be difficult, especially when you lack the financial capacity to do so. You’ll be subjected to a barrage of calls, maybe visits, or sometimes, minor harassments if your debts gets sold to a hostile collection agency with zero regard for the law. Sleeping will be hard, so will keeping up with your bills. In addition, your finances and mental health may be affected on the long run if you keep on delaying the repayment of your debt.
If your debts seems like a huge mountain or an insurmountable tax, I’ll advice that you negotiate or embrace debt relief programs. While debt negotiation can be quite challenging, it remains one of the best ways to becoming debt free, without having to pay a dime or all that you owe. If you are lucky and a creditor offers you forgiveness of debt, it means that you aren’t required to pay a dime or the entirety of what you owe (depending on the creditor’s agreement).
My Creditor Cancelled My Debt, What Next?
After cancelling your debt, the creditor may send you a form 1099-C, Cancellation of debt indicating the amount of debt cancelled coupled with when it was cancelled, including other important details.
If the creditor sent you a Form 1099-c displaying wrong information, don’t hesitate to contact him to make necessary amendments. On the other hand, if the creditor sent you this Form and is still making effort to collect the debt, the creditor may not have cancelled the debt and, hence, you may not have income derived from a cancelled debt. Ensure you check in with the creditor to get a clearer picture of your case.
What Is a Cancellation of Debt Income?
To understand what a cancellation of debt income is, you need to understand what a cancelation of debt (COD). COD occurs when a creditor decides to relive you from a debt obligation. You may be able to negotiate with a creditor directly for forgiveness of debt. You can also receive debt cancellation via debt relief program or by filing for bankruptcy.
With that said, what is a cancellation of debt income?
This is an income acquired when a debtor decides to eliminate your debt. It is considered as an income because you aren’t required to pay back the money. Since debts forgiven by a creditor is considered an income, are you required to pay tax in it?
Of course, debts forgiven by a creditor are taxable as income. Such debts will be recorded by the creditor and reported to a debtor as income on a form 1099-C. However, there are some exceptions. The cancelled debt is not taxable if the law specifically allow you to disbar it from your gross income.
Other Exceptions:
According to the Internal Revenue Service, the following are not deemed cancellation of debt income:
- Debts revoked as inheritance or gifts
- Some student loans that fulfil certain criteria
- Educational loans or debt relief programs that help provide health services
- Revoked debt that would be deductible if an individual as a taxpayer, paid it
- A qualified purchase price reduction on a property offered by the seller
- Amounts of student loans offloaded upon the death of incapacitation of the student
Worthy to note is that, you are required to report the taxable amount of cancelled debt as income on your tax return for the year when the cancellation took place regardless of if you received a correct form 1099-C or not.
Ways to Cancel Your Debt:
- Debt relief programs
- Negotiating with creditors
- Bankruptcy
Rather than sit down and do nothing about your debt, I’ll advice that you take action. The earlier the better. If required, you can see a financial expert.
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Is Cancellation of Debt Income Ordinary or Capital?
If you are familiar with some financial terms, I believe you know that ordinary income and capital income are among the types of income that exist. While capital income is regarded as income that is derived from capital, that is, from wealth itself, rather than a production or direct work, ordinary income is simply a money earned from working. With that said, what do we classify the income derived from the cancellation of debt as? Ordinary income or capital income?
The income derived from the cancellation of a debt can be categorized as an ordinary income as it is not incurred from the sales of assets, dividend income or the possession of a rental home.
Since income derived from the forgiveness of a debt is considered as an ordinary income, when filing your tax, you are required to file as an ordinary income tax.
