Do You Owe Taxes for Forgiven Income?

I just heard from "Missy," a woman whom I had spoken with some time ago about her debt. She is now out of debt. She's scrimped, saved, budgeted and settled her debts. But now she's run into a hurdle.

While working on her taxes, she's discovered that she may owe the IRS a big chunk of change due to debts she negotiated with her creditors.

Here's what happened: She managed to get some of her creditors to agree to accept less than the total amount owed in order to resolve her debts. In other words, they "forgave" some of the interest and penalties they had assessed. The problem is that the IRS considers forgiven debt "income" and expects you to pay taxes on that amount as if you received it.

"But they only wrote off only interest and penalties that were outrageous to begin with" argues Missy. Unfortunately, Uncle Sam doesn't care.

We are not talking about a small amount here. In Missy's case, the forgiven debt (reported by her creditors on Form 1099C) totals around $20,000. That could definitely result in a big bill from the IRS come April 15th.

Missy's tax preparer wasn't familiar with Form 982, which may allow her to avoid paying tax on that income. She must find out if she qualifies by demonstrating that she was insolvent when the debt was forgiven.  If so, Form 982 will allow her resolve the issue and avoid going back into debt to pay the IRS.

Given all the credit problems we're seeing, the IRS may be seeing a lot of Form 982s!

Gerri Detweiler – Personal finance author, radio host and credit expert. Gerri contributes budgeting, debt recovery and savings information online.