A forgiven debt is an occasion of celebration for the debtor. For the IRS, it means more taxes. If a lender forgives or cancels a debt for any reason, the IRS sees it as income and charges tax on it. You are required by law to pay income tax on your cancelled debt unless you qualify for an exception. Also remember that for the IRS a debt is a debt whether you are personally responsible for paying it or are liable only to the extent of the property securing the debt. Even if your debt has been partially forgiven, you will still need to pay taxes on the amount forgiven.
To pay taxes on a cancelled debt, you need to file Form 1099-C, Cancellation of Debt. Before filing, you must ensure that the debt is cancelled and report how much of it is cancelled. Many times, miscommunication or misunderstanding between the lender and the debtor leads to tax complications.
You must only file Form 1099-C if you are certain that the debt has been cancelled. On the form, you need to report the amount of debt that has been forgiven, cancelled or discharged. If the creditor tries to collect the debt after you have filed the form, it means that the debt is not cancelled. To avoid such a situation, you must get a written consent from the creditor that the debt has been cancelled.
Often, taxpayers are not aware that forgiven debt is taxable, and they do not report it and pay taxes on it. This leads to tax debt. Taxpayers who believe that they correctly filed their tax return find that they are in tax debt when they receive a notice from the IRS. Due to the charging of penalty and interest on the tax debt amount, they end up paying more in taxes than they would originally have.
To stay compliant with the tax laws, you must check whether you qualify for an exception, and if not, report the cancelled debt to the IRS and pay taxes on it on time.