When working manage your debts, there are cases in which a lender may forgive certain debts. This is common in credit negotiations, mortgage loan modifications and short sales; whereby a lender may waive delinquency fees or deficiency balances associated with a loan. When this happens the debtor is relieved of their financial obligation over these fees; however, they may still face tax obligations over the forgiven debt.
When a debt is forgiven the lender will report the transaction to the IRS in the form of a loss. When this happens, the IRS will require the debtor to file Form 1099-C in order to claim the forgiven debt on their personal tax liability statement. Technically, the IRS considers debt forgiveness to be a form of income for the debtor because they have been absolved of paying their debt to the lender through the waiver. This comes as a surprise to many and can result in tax debt when the debtor cannot afford to pay the liability over the cancelled debt.
There are some exceptions to the rule that debt forgiveness is taxable income. First, if the forgiven debt was discharged in bankruptcy, is will not be considered taxable. Therefore, if a debtor loses their home through foreclosure, sells the home in a short sale or files for Chapter 7 bankruptcy, the IRS may not require the debtor to claim the waived debt. Second, if the debtor is considered financially insolvent when the debt is waived, the IRS may not require the transaction to be taxable. However, this may only be claimed if the debtor is considered to have more in total debt value than the fair market value of their assets.