Read Time: 3 to 5 mins.
Summary
IRS: Debt = Income
You: …huh?!
IRS: You owe me money (tax).
You: Damn…
Something that always surprises my clients is the concept of “debt forgiveness.” Think about the following example:
Bob spends $50,000 with his credit card on pizza, ipads and etc., but he realizes that he can’t afford his “ghetto fabulous lifestyle.” (This is your average American) After a million final collection notices and harassing calls from the debt collectors at the end of the year, the credit card company offers Bob a deal because they know that he’s never going to pay. If Bob pays the company $10,000, then the credit card company will offer a discount on the debt or they will forgive $40,000 of Bob’s debt. Bob pay the credit card company $10,000 and is forgiven $40,000 in debt. Now, the IRS calls Bob and lets him know that he’s got a new daddy.
Bob’s Mindset:
I didn’t make any money! Why do I owe tax on money that I never earned?! This is BS.
IRS’ Mindset:
Bob spent $50,000 on pizzas, ipads, and other toys on borrowed money. All of a sudden, Bob magically doesn’t owe the $50,000 anymore, thus he’s “gained or earned something.” Income in the U.S. is “broadly conceived” and defined as “all income from whatever source derived except as otherwise provided.” Now, Bob owes tax on $40,000, which is the amount that the company forgave.
Awesome surprise!
There are a few exceptions:
1. Insolvency is when you’re so broke that you have more debt, than assets and income. This is the point where you’re totally screwed financially.
2. Bankruptcy doesn’t count as income because the IRS already knows that you’re broke and can’t afford to pay.
3. Qualified Principal Residence Indebtedness is either your mortgage or your home equity loan. If you’re debt is forgiven because it’s specifically related to the home you live in, then you are allowed to exclude up to 2 million (1 million if married filing separately for the tax year) from income for the years between 2007 through 2012.
Note – I’ve met a lot of people who’ve been hosed in the recent subprime debacle and have used the “Qualified Principal Residence Indebtedness” exception.
Conclusion:
The IRS always gets their pound of flesh, even when on money you didn’t know about.