If someone owes you money and you decide to forgive him the debt, it can be a good idea to formally document this so there's no dispute later. In some cases, this may legally qualify as a gift, so you should determine whether forgiving the debt will cause you to incur gift tax.
Debt Cancellation Agreements
If someone owes you a substantial amount of money and you decide to forgive some or all of the debt, you can draw up what is called a debt cancellation agreement. This can be especially important if the original debt is documented on paper so there can be no disputing later about whether the matter was resolved to both parties' satisfaction.
The document should name the lender and borrower, specify how much money was lent, when it was lent and how much debt will be forgiven. You should also specify exactly when the forgiveness goes into effect and have everyone involved sign the document and retain their own copies in case there's any kind of dispute later on.
If you have any questions about whether a particular agreement will be seen as legally valid in your state, you may wish to consult a lawyer for advice in order to make sure that a court will see it as a valid contract if you have any sort of dispute.
Review the Gift Tax
If you lend someone money and later forgive the debt, this may legally be interpreted as a gift. The IRS is often exceptionally questioning of loans between family members since it is easy to try to pass off a taxable gift as a nontaxable loan. Generally, if you give someone more than $15,000 in a given year, that is considered a taxable gift.
Usually, for tax purposes, more formal loans are less likely to be scrutinized as potential gifts. So while it may seem crass to ask a relative to sign a promissory note, agree to pay by a particular date and make regular interest payments, it can be in your financial interests to do so in order to avoid being charged tax.
If you're lending a family member money and don't want it to be classified as a gift, you often need to charge her a minimum interest rate called the applicable federal rate, since lending with no return to the lender is itself seen as a gift.
Of course, you may wish to forgive someone a debt he owes you regardless of the tax ramifications.
- A forgiven loan may be subject to gift tax. According to the IRS, as of 2012, you can give $13,000 per year gift-tax-free to anybody for any reason. If your gift is larger, you have to file Form 790, the gift tax return. So if you loan a friend $100,000 and forgive $50,000 of it, you may be liable for gift tax on $37,000 the year of the forgiveness. However, if you choose to forgive only $13,000 per year for three years and $11,000 the fourth year, you may be able to sidestep the gift tax. IRS gift tax rules are complex and regularly revised. Consulting a tax professional is recommended.
- IRS: Publication 950 – Introduction to Estate and Gift Taxes
- IRS: About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return
- Investopedia: Gift Tax
- LegalMatch: Debt Cancellation Agreements
- Cohen & Co: Tax Ramifications of Loaning Money to Family Members
- NOLO: Gifts That Could Land You in Tax Trouble