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The State of Connecticut recently announced that the fourth round of its partnership with Undue Medical Debt has relieved more than 97,000 state residents of a total of nearly $325 million in medical debt. Overall, more than a quarter of a million residents have had over half a billion dollars of debt cancelled under the program.
Sadly, among the first comments we see on social media in response to this has been somebody saying “Yes, but you’ll have to pay taxes on that.”
While it is true that debt forgiveness can generate taxable income, this particular initiative avoids it. Under this program, according to Undue Medical Debt, the debt is “abolished as a charitable act by a detached and disinterested third party”. This fits under the gift exception established in tax law.
The knee-jerk (emphasis on “jerk”) reaction of some on social media to poo-poo every bit of good news is lamentable and sad. Luckily, such trolls are often quite wrong as in this case.
In addition to the gift rule, there are three other exceptions/exclusions to the taxability of forgiven debt:
1) Under the deductible-debt exclusion, Section 108(e)(2) provides no income is realized to the extent payment of the liability would have given rise to a deduction. IRS guidance applies this exclusion mainly to cash-method taxpayers where the unpaid item would have been deductible if paid.
2) If the debt is discharged in a title 11 bankruptcy case, the amount is excluded from gross income.
3) If you were insolvent (i.e. your liabilities exceed the fair market value of your assets) immediately before the discharge of the debt, income is excluded up to the amount of insolvency.
Lastly, we also just want to remind people that while paying tax on debt forgiveness might leave a sour taste for some, you can think of that as settling the debt for pennies-on-the-dollar. If your marginal tax rate is 12% for example, then that is effectively settling with an 88% discount. Paying 12 cents for a dollar seems like a good deal to us.
If you have a question on taxation of debt forgiveness, give us a call.