Process

• Once a lender forgives a borrower's debt, the borrower will receive a tax form in the mail. It will already identify the borrower, the lender and the amount forgiven. The borrower must include this form when filing taxes for that year. Otherwise the borrower is subject to additional penalties and fines. He will have the opportunity to demonstrate that the forgiven debt does not qualify as income based on one of the exceptions listed below.
  
  

What Qualifies?

• Forgiven debt qualifying as income for the IRS includes short sales on real property, credit card debt settlements and negotiated pay-offs with third party bill collectors. Bank foreclosure on property may also qualify if the property later sells for less than the amount owed on the loan. The forgiven debt in any settlement must equal $600 or more.
  
  

Exemptions

• There are a number of circumstances in which the IRS does not handle forgiven debt as income. Debt settlements arranged as part of a bankruptcy do not qualify. School loan debts forgiven based on the borrower pursuing certain public interest occupations do not qualify. Certain farm loans are exempt. If the debt is contested by the borrower, or the result of identity theft, forgiveness does not qualify as income. If the borrower is insolvent at the time of the forgiveness, the canceled debt does not qualify as income. Finally, forgiveness treated as a gift is exempt. For example, a friend or brother who forgives a loan is making a gift. In this case, a gift tax may be applicable.
  
  

Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA)

• The MFDRA is effective for mortgage debt canceled between 2007 and 2012. Forgiven debt does not qualify as income if the mortgage was to purchase, repair or build on the borrower's primary residence. The forgiven debt must have been part of a mortgage restructuring or cancellation of debt following a foreclosure. Individuals are limited in this time period to $2 million of exemption and married couples filing separately are limited to $1 million each. The forgiven debt and the reason for exemption must still be filed on tax returns.
  
  

Forms

• The IRS uses three principal forms to address forgiven debt: the 1099-A, 1099-C and form 982. Consumers need not worry about the 1099-A which is used only by the lenders or collectors responsible for forgiving the debt. After the debt is forgiven, the lender must send the borrower a 1099-C which the borrower will use to report income to the IRS. Form 982 is used to claim exemption for any of the reasons listed above, including exemption under the MFDRA.