Tax Effects of Defaulted Promissory Notes

If you've borrowed money, chances are you've signed a promissory note. A promissory note is a signed promise in which one party agrees to pay another party a specific sum of money on or by a specific date. It's a legal document that obligates the borrower to repay the loan associated with the note. Defaulting on a promissory note could have tax consequences now and for years down the road.

Forgiveness

A default on a promissory note means the lender on that note did not receive payment for it. If the lender believes the debt is noncollectable, it may cease collection of it and write off the unpaid debt as a loss against its taxable income. Of course, the lender reports this loss to the Internal Revenue Service and will issue you a 1099-C tax form. If the forgiven amount exceeds $600, you may have to report it as income and pay taxes on it. This could increase the amount of taxes that you owe to the federal government.

Student Loans

If the promissory note was for a student loan, you could face a different type of tax issue. Defaults on a student loan, such as a subsidized or unsubsidized student loan, could result in the garnishment of your federal tax return to pay the debt. You could also have your state income tax return garnished. Your returns can be garnished year after year until the debt is paid or arrangements are in place to pay it.

Co-signers

Both the primary borrower and cosigner on a student loan are held responsible when a loan goes into default. A co-signer agrees to pay the debt if the primary borrower defaults. So even if you are not the primary borrower, you could still have your federal or state tax returns garnished to pay that debt if a promissory note you co-signed is defaulted on. If you are a co-signer and learn that the loan is in default, it may be advantageous to make a payment arrangement with the lender to bring the loan out of default status.

Exceptions

If the lender forgives $600 or more of a debt, you may not have to include that forgiven debt on your income taxes under certain circumstances. This includes a student loan forgiven because you worked for a specific employer or in a particular profession as promised when the loan was taken out. You also don't have to pay taxes on the forgiven amount if you discharged the debt in Chapter 11 bankruptcy or if you were insolvent before the creditor agreed to settle or write off the debt. Insolvent means your debts exceed the value of your assets.

About the Author

Mack Mitzsheva is a tax lawyer, personal finance expert and the author of the forthcoming ebook, "10 Best Places to Work Online." Mitzsheva is also a social media entrepreneur with five successful sites under her belt. Always innovative, Mitzsheva is currently developing a cutting-edge budgeting app for newlyweds.