Debt and credit can be useful tools to help reach goals, but how do they impact your taxes? Having debt, in some cases, can reduce taxes, but in most cases, it is not helpful. Having debt canceled can be incredibly helpful with personal finances and budgets, but sometimes results in more taxes. 

Let’s start with discussing some cases where debt impacts taxes. Please note the focus of this discussion is on federal income taxes. State laws will vary. 

Debt and Taxes

1) Mortgage debt can reduce tax liability. However, it’s not helpful for most people because in order to benefit, a taxpayer has to itemize. For itemizing (using a Schedule A form) to reduce tax liability, your itemized expenses have to add up to more than the standard deduction. Most of the time, this does not happen.

The standard deductions are: $25,900 for joint filers, $19,400 for heads of household, and $12,950 for single filers and those married filing separately.

The most common itemized deductions under current tax law are: 

• mortgage interest, 
• points paid on a mortgage (sometimes), 
• private mortgage insurance (insurance that you pay for the lender, not you), 
• RE property taxes, 
• personal property taxes (often vehicles), 
• state income taxes or state sales taxes, 
• and charitable contributions. 

All of those deductions have to add up to more than the standard deduction to be helpful. For example, if you are a joint filer and all of these add up to $26,900, then you can itemize and deduct $1000 more than if you take the standard deduction. If you are in the 12% tax bracket, this will mean a tax savings of $120.

Pro Tax Tip: Be careful with refinancing, home equity loans, and home equity lines of credit. Only the portion of the interest associated with borrowing that goes back into the home (or possibly another home) is a valid deduction. 

See Schedule A instructions for more details on itemizing with mortgage debt interest.

2) Student loan debt may reduce tax liability through the student loan interest deduction. Up to $2500 of paid interest can be deducted. To claim the full deduction, your Modified Adjusted Gross Income (MAGI) must be below $70,000 ($140,000 if you file a joint return with your spouse). The amount permitted to be deducted is reduced slowly until the taxpayer reaches a MAGI above $85,000 ($170,000 for joint filers), at which point it is completely phased out. There are restrictions on when and whom may deduct student loan interest, and these can be found in IRS Publication 970, Tax Benefits for Education. 

Pro Tax Tip: When married and filing a married-filing-separately tax return, the student loan interest cannot be deducted. However, some taxpayers who’re on income-driven repayment plans find it more beneficial for their overall finances to file married-filing-separately tax returns. This is because only the borrower’s income is used to determine the required monthly student loan repayment when filing a Married Filing Separate tax return. You can find more information on income-driven repayment plans here. 

3) Business or self-employment debt is a big area for deductions. The important thing to remember here is the phrase “ordinary and necessary.” For example, you can’t buy a boat and deduct the buy price and interest on a loan if the boat isn’t needed for your business. However, if there is a business need and you pay interest on a loan for the expenditure, it is most likely deductible (or part of it is likely deductible if it’s partially used for business). More information on deducting business debt can be found under Publication 535, Business Expenses.

Canceled Debt 

Having debt canceled or forgiven can be very helpful in improving your financial situation. However, sometimes canceled debt is taxable, and you will often receive a Form 1099-C reporting the canceled debt. The lender is required to provide the 1099-C for canceled debt of $600 or more unless they know one of the exceptions applies. Please note that states have very different laws about the taxability of canceled debt, so canceled debt may or may not be taxable under state income taxes depending on the state. 

Some common exceptions (or exclusions from gross income) under current law for federal taxes are:

1. Federal student loan forgiveness programs
2. Debt canceled through Title 11 bankruptcy
3. Qualified principal residence indebtedness
4. Debt canceled to the extent insolvent. This basically means that if your debt exceeds your assets at the time the debt is forgiven, some or all of the canceled debt may not be taxable. The IRS provides a worksheet to determine how much, if any, debt is taxable in this scenario. This worksheet can be found on page 7 of Publication 4681.
5. There are other exceptions or exclusions, which you can find here.

Insolvency Crash Course

Insolvency is an important concept since it is often missed by taxpayers when filing their tax returns, even though it is the most common way to reduce tax liability due to canceled debt. 

Insolvency Example:

Our friend Fred has a $40,000 personal loan canceled. At the time of the cancelation, Fred has a house and a car and no other assets, but he does have some additional liabilities.

EQUATION: Total Assets – Total Liabilities = Net Worth

So Fred is insolvent by $30,000. Since $40,000 of debt was forgiven, this means $10,000 is taxable income. 

Note: You should use the IRS-provided worksheet or the worksheet within the tax software that is used to prepare the return. This will help ensure you don’t miss anything and that your calculation is accurate. 

Pro Tax Tip: Some aspects of tax season can be complicated. Anytime you have new questions regarding debt taxes, make sure you research the answer or reach out to a professional. 

It’s risky to rely on someone saying, “I just did it, and I didn’t get in trouble.” The links to the resources above can help with that research, and most tax software has good tools to help you find answers and resources to figure out the more complicated tax topics. When you aren’t certain, or if you simply don’t want to deal with the tax prep yourself, it may make sense to pay for the services of a tax professional. 

Jerry Zeigler

Jerry Zeigler is a Navy veteran who serves service members with financial counseling and education. As an Accredited Financial Counselor®, he is a member of the Better Financial Counseling Network and is the owner of JZ Financial Management. As a tax professional and Enrolled Agent, he has a passion for helping taxpayers navigate taxes.