This is a confusing subject for many. If the lender forgave the debt, why would you have to pay tax on it? Hasn’t it been “forgiven”? Unfortunately, the IRS does not think like the rest of us. In their eyes, you received the money in the form of cash, merchandise, eating out or other items when you took out the loan. As a result, it was income to you just like a paycheck. Normally you pay a loan back, so under “normal” circumstances that income is not taxed. It becomes more complicated if you don’t pay the loan back and the debt is forgiven. You see, in the eyes of the IRS, you received the income but the paying back part was eliminated thus the IRS considers the money (the amount forgiven) to be regular income, which is taxable. It doesn’t matter that you no longer have the cash or the merchandise. You had it at one time and were not taxed on it, so the IRS is going to tax you on it now.
If you choose to ignore it, you can get yourself into trouble with penalties and interest if the amount of the forgiven debt was $600 or more. Lenders are required to report the amount of money forgiven if it is $600 or more. They will issue a 1099-C, Cancellation of Debt. A copy of this form will go to you and a copy will be sent to the IRS. That gives a heads up to the IRS and they will be expecting the amount to be reported. Failure to do so can result in red flags and possible selection of your return for further review or audit.
On the positive side, if the cancellation of debt occurred between 2007 and 2013 and was for a mortgage that was used to “buy, build or improve” your primary residence, the Mortgage Forgiveness Debt Relief Act of 2007 excludes it from taxation. This is only applicable to your primary residence where the cancellation occurred during those years. Second homes or vacations homes do not qualify for tax exclusion.