Is Forgiven Debt a Taxable Income?

Our article on 10 crucial debt reduction mistakes was posted on the Don't Mess with Taxes blog at: and it has become quite popular in terms of viewership. However, the point we made needs further elaboration and explanation. In this article, we will do just that!

Forgiven Debt is Taxable Income

If you have had a debt settlement agreement with your debtors where they wrote off your debt, this automatically creates taxable income for you! According to IRS Form 980, if you receive a debt settlement of $600 or more, it will automatically be reported to the IRS and the beneficiary of this settlement will have to include this forgiven debt in his taxable income. Therefore, if you have had a large portion of your debt forgiven, you should not be totally happy because you will have to pay tax on this amount!

Is forgiven debt really a taxable income? Suppose you owe your credit card company $12000 in credit card debt. You carry out a debt negotiation process with Visa or MasterCard and get them to reduce your credit card debt balance from $12000 to $7000. While Visa has lost $5000 ($12000 - $7000), the IRS has earned itself taxable revenue of $5000. That's right, this $5000 balance which you did not pay is known as Discharge of Indebtedness, or DOI income and you will be taxed on this amount! As a matter of fact, the debtor will issue you a Form 1099 which will detail the debt reduction benefits that you received.

What if the debtor forgets to send you a Form 1099? Does this mean the reduced debt amount you received (i.e $5000) is not taxable? No! Even though the debtor hasn't sent you a Form 1099, the taxable income may have been reported to the IRS. This means you will have to be honest and include this income in your tax return, at the end of the year. Barbara Weltman, a Tax Attorney and Author of J.K. Lasser's Tax Savings in your Pocket quotes, "Any debt that is forgiven is counted as income, and you owe taxes on the amount that's forgiven."

Steve Rhode, Co-Founder of MyVesta (a debt consolidation & credit counseling firm) says, "It's a great way for the IRS to make money." What does this mean for you both as a taxpayer and as beneficiary of debt reduction? Should you therefore not let your credit card company reduce your debts because you will have to pay extra tax if they do so? Well it depends, you have to look at it from different angles. Barbara Weltman says, "What you have to do is recognize you'll have to pay taxes and factor that into your negotiations and your financial planning." Will the extra taxable income you receive push you into a higher tax bracket, thus forcing you to pay even higher taxes? Or will you still be in your current tax bracket and be able to handle the extra tax payments you will have to make?

There are 3 situations under which forgiven debt is NOT included in your taxable income:

1) Battled Contest

If you dispute an amount charged on your credit card and win the debt settlement, you are excluded from the Discharge of Indebtedness (DOI Income) rule. For example, Visa might say you owe $1500 in credit card debt due to a recent purchase of expensive shoes. You know you haven't purchased those shoes and dispute the bill and the court case goes on for weeks. In the end, you agree to pay Visa $150 to reach a debt settlement. Since your debt owed has legally been reduced from $1500 to $150, you would be liable for the DOI income rule. However, since you won this case by a protest or a dispute (in court or verbal settlement), you are NOT required to include this amount as part of your taxable income.

2) Bankruptcy Declaration

When you've declared bankruptcy and are making for example only 10% of the original debt payments you owed, the other 90% is excluded from the Discharge of Indebtedness Income rule.

3) Insolvent Financial Condition

When you are insolvent, meaning your liabilities owed exceed your total assets, you are not required to pay any tax on any debt reduction or debt settlement benefits you receive.