Although lender agreements require you to make your debt payments as agreed, in certain cases a creditor may cancel some or all of your debt. This may occur when you negotiate a settlement with a creditor for less than the full balance of your account. A deed in lieu of foreclosure, in which you relinquish the deed to your home to your mortgage lender, also results in debt cancellation. In some cases, debt cancellation may have tax consequences.
If you settle a debt with a creditor for less than the full balance, the creditor reports the forgiven amount to the Internal Revenue Service on Form 1099-C and sends you a copy of the form. If the settlement results in cancellation of more than $600 of debt, you will have to pay taxes on the forgiven amount as earned income. You do not have to pay taxes on canceled debt amounts less than $600.
Because the IRS considers canceled debt as earned income, you will pay taxes on forgiven debt of more than $600 at the standard tax rate for your income bracket. If the earned income from the debt cancellation places you in a higher tax bracket, though, you will be taxed at the higher rate for amounts applicable to that tax bracket.
Deed in Lieu of Foreclosure
Although a deed in lieu of foreclosure results in cancellation of your mortgage debt, you may not have to pay taxes on the forgiven debt if the canceled loan meets certain criteria. As of 2011, taxes do not apply if the loan was for your primary residence, you are insolvent or you filed bankruptcy before closing on the home. If none of these conditions apply, taxes may apply to the deficiency, which is the difference between the canceled loan balance and the value of the home.
Although debt cancellation can increase your federal tax liability in some cases, the benefits of debt cancellation may outweigh the added tax cost. Settling a debt can prevent the creditor from suing you to recover the debt, which can lead to wage garnishment, bank levies and property liens. A deed in lieu can help prevent foreclosure on your home, but if the lender opts for foreclosure, you may be responsible for paying the deficiency in most states.