What Happens if I Don’t Report Canceled Debts as Taxable Income?

Oh boy, you’re in a bit of a pickle here. Getting debts forgiven or canceled can feel like a blessing—who doesn’t love having less debt? But unfortunately, the taxman may see it differently. Here’s the lowdown on what can happen if you don’t report canceled debts as taxable income.

The Big Rule

In most cases, if a lender forgives or cancels a debt you owe, the canceled amount is considered taxable income by the IRS. This means you’re required to report it on your tax return and pay income tax on it—even though you didn’t actually receive any cash. Bummer!

The logic is that the debt forgiveness freed up assets for you, so it’s essentially the same as receiving income. There are some exceptions to this rule, which I’ll get to in a bit. But in general, if a credit card company, bank, or other lender cancels a debt you owe them, be prepared to include that canceled amount as income on your tax return.

What Happens If You Don’t Report It?

If you have taxable income that you don’t report properly on your return, you could face penalties, interest charges, and other hassles with the IRS. Here are some potential consequences:

• The IRS could audit you. If the IRS has reason to believe you failed to report income, they may select your return for an audit. This means they’ll comb through your finances with a fine-toothed comb. No fun.
• You may have to pay back taxes. If the IRS determines you didn’t report taxable income, you’ll likely owe back taxes on that amount, plus interest and penalties. This can really add up over time.
• Penalties may apply. Depending on the specifics, you could be hit with penalties for filing an inaccurate tax return or for failure to report certain income. The penalties can be up to 75% of the unpaid tax!
• Interest charges accrue. Any back taxes and penalties you owe will start accruing interest until they’re paid off. The IRS interest rates are pretty steep.
• Criminal charges are possible. Willful tax evasion is a criminal offense. If the IRS believes you intentionally tried to conceal taxable income, criminal prosecution is a possibility.
• Your future returns may be examined more closely. Once you’re on the IRS’s radar for unreported income, they tend to keep a closer eye on your returns going forward.

As you can see, it’s really not worth trying to hide canceled debts from the IRS. Getting caught can lead to financial pain and stress you just don’t need.

When You Don’t Have to Report Canceled Debt

Now for the good news! There are some situations where you may be able to exclude canceled or forgiven debt from your taxable income:

• Bankruptcy: Debts discharged through bankruptcy are not taxable in most cases. Just make sure it’s dischargeable debt under the bankruptcy code.
• Insolvency: If you can prove you were insolvent (liabilities exceeded assets) immediately before the debt was forgiven, it may not be taxable income. There are specific IRS tests for insolvency.
• Mortgage Forgiveness Debt Relief Act: This law allows up to $2 million of forgiven mortgage debt used to buy, build or substantially improve your principal residence to be federally tax-exempt through 2025. Make sure you meet the eligibility requirements!
• Student Loans: Certain student loan debt forgiven through government programs or nonprofit work can be excluded from income taxes.

There are a few other more obscure exclusions too. The bottom line is you may be off the hook with the IRS if your canceled debt falls into one of these categories. Consult a tax pro to be sure.

What If You Already Filed Without Reporting Canceled Debt?

Don’t panic, but don’t ignore it either. Here are some tips if you just realized you failed to report canceled debts on a prior tax return:

• File an amended return ASAP: You’ll need to file an amended return for the year the income should have been reported. Better to correct it voluntarily before the IRS catches the mistake.
• Be ready to pay up: You’ll likely owe back taxes, interest, and possibly penalties. The sooner you pay, the less interest builds up. Consider setting up a payment plan if needed.
• Write an explanation letter: Include a letter with your amended return explaining what happened. Taking responsibility can help reduce penalties.
• Seek tax help: Consulting a tax professional is wise to ensure you take the right steps. They can help manage interactions with the IRS too.

While this situation is less than ideal, handling it head on is the best damage control. And now you know to properly report any canceled debts in the future! The taxman cometh for us all, so stay in his good graces.