Well yes, it is true that you will be taxed on earned income if your assets are greater than your liabilities at the time of settlement. While I certainly have a lot of beefs with the nonsensical way that the IRS does a lot of things, in this instance, what they do makes sense from an accounting perspective.

Based on your site, I am sure that you know this but for the benefit of my readers let me explain further. Lets say I loan you 1,000 dollars. You receive 1,000 but do not pay income tax on it. It is assumed that I have already paid the income tax before having it as disposable money to lend to you. If you pay me back, then I have no tax liability on the money you paid me because it was just repayment of money that I already paid tax on.

However, if you are unable to pay me, and I forgive the 1,000 dollar debt, then I am going to write off that 1,000 dollar loss on my next years tax return and have it offset 1,000 in current income that I will not have to pay tax on. Therefore the IRS loses out on the ability to collect tax on 1,000 that I earn this year. Well if they can’t collect it from me, they are going to look to the person that received that 1,000 to collect it from.

So on the borrower side, if I forgive that 1,000 dollars, then you would receive 1,000 dollars in income, since you are not going to pay it back. Since the IRS lost the ability to collect the tax on that 1,000 from me, they are going to go to the person on the other side of the accounting equation to collect their tax.

So from an accounting perspective, the IRS is simply looking to regain the revenue it lost from me writing off the debt. That is actually fair. And it really is more than fair when you consider, if the debtor is in fact insolvent than the IRS lets the debtor slide and is not able to collect any revenue on that transaction. In other words, the lender gets a tax break, and the borrower receives tax free money.

Further, even if the borrower is solvent and is required to claim the 1,000 as 1099 earned income, in many cases the borrower can be in a lower tax bracket than the lender. So if I get to take a 1,000 deduction at the highest federal tax rate, and the borrower only has to pay taxes on that 1,000 at the lowest federal tax rate, the IRS is still out the difference.

To recap, I am certainly not defending the fact that the IRS is in every facet of our lives and they TAX the living you know what out of everything. All I am doing is pointing out that in this specific example, from an accounting perspective, it does make perfect sense that they would want to tax the borrower on a forgiven debt. And to the IRS’s credit, if the borrow is insolvent they will let it go and just not collect any revenue.

Most consumers that are in a position to require that a debt be forgiven are insolvent, so usually when a consumer receives a settlement from a creditor, they are not likely to owe a tax. Again, you always want to consult with a tax professional to help determine if you will be taxed on the forgiven debt.

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