Unwelcome tax surprises may await those with debt

Americans struggling with debt might get some additional unpleasant tax surprises this year: From needing to pay taxes on forgiven debt to seeing reduced deductions as a result of loans that are in forbearance, some taxpayers are poised to owe more than they might realize. Here are three ways debt can lead to tax surprises.

Owing taxes on forgiven debt. If you have had student loan or credit card debt forgiven, then that canceled debt is often included in taxable income during the year that it is forgiven, explains Richard Bolger, a bankruptcy attorney in Fairfax, Va. You are required to report all taxable income, including forgiven debt, to the IRS.

To avoid surprises, Bolger suggests carefully reading the fine print that comes with the debt settlement offers, and to ask questions before agreeing to anything.

Reduced deductions. Thanks to COVID-19 relief programs and the CARES Act, many Americans took advantage of forbearance programs for student loans and mortgages in 2020.

That means they temporarily paused their loan payments; interest typically still accrues during this time, but consumers are not paying it. And if you are not paying deductible interest, that means you can't take it as a tax deduction, which could potentially raise your tax bill.

"Taxes would presumably be higher in a tax year no deductible interest was paid, all other things being equal," Bolger said. But many Americans lost jobs or other income, so that could mean a lower overall tax bill.

When it comes to mortgages, many taxpayers can't deduct them anyway because they don't itemize their deductions, opting instead for the standard deduction.

Losing your refund to debt collectors. While collection agencies can't take your refund from the IRS directly, it's possible that they can take it once it's in your bank account if the account is at risk of garnishment because of a debt collection judgment, said Lauren Saunders, associate director at the National Consumer Law Center.

If the account is garnished, she adds, many states have laws that protect part of the money. "But in most states, the consumer has to go to court to assert the protection and must act quickly," Saunders said.

Another option, she adds, is to request the refund by paper check instead of by direct deposit, or to immediately withdraw any funds needed. That can protect the money from being immediately seized by collection agencies.

E-mail: kpalmer@nerdwallet.com. Twitter: @kimberlypalmer.