In California, when you have certain types of debt canceled, such as through bankruptcy, you are no longer obligated to repay the money to your creditor. However, this can come with a catch. Sometimes, you may have to pay taxes on the forgiven debt. The following describes when this situation could apply.
Canceled debt and your taxes
If you land in a situation where you cannot pay your debts, you may choose to file for bankruptcy protection. Depending on the bankruptcy type, you may either restructure your debt or have it forgiven. Bankruptcy exemptions let you keep certain assets, such as your primary home and a limited amount of savings that do not need to go toward repaying debt.
Suppose you owe $4,350 on a credit card, and after going through the bankruptcy process, the court discharges the debt, and you no longer need to repay your credit card company. The discharged amount becomes canceled debt, and the government typically sees this amount as money given to you as if it were income. In this case, the Internal Revenue Service (IRS) would require you to pay taxes on that $4,350 amount.
Exceptions to the rule
In a few instances, you can receive financial discounts or assistance to reduce the amounts you owe without triggering any tax implications. If you have received financial help with your mortgage from the government through programs like the Home Affordable Modification Program, you do not owe taxes on this amount. If you received student loan debt forgiveness through a program such as the Public Service Loan Forgiveness Program, your forgiven loan amount is also non-taxable.
Reporting canceled debt to the IRS
If you receive debt cancellation, the creditor will send you tax form 1099-C, which details the amount of debt waived or forgiven by the creditor. You would include this amount on your tax return for the tax year the debt forgiveness occurred. The creditor sends a copy of your 1099-C to the IRS, so you must include the amount on your taxes to avoid penalties, late fees or an audit.
Debt cancellation can provide a crucial financial lifeline, although it comes with a cost. Considering forgiven debt in your tax planning will ensure that you file an appropriate return and pay the correct taxes owed without incurring further issues or fees.