Paying taxes on debts that are forgiven or cancelled

Paying taxes on debts that are forgiven or cancelled is a concern on the minds of many people who come to my office for advice. They are worried about having to pay additional taxes as a result of resolving issues with their creditors. These tax questions can surface in short sales, debt consolidation arrangements, mortgage modificationsbankruptcy, or any transaction where the bank or creditor receives less than the amount originally owed.

When talking about the tax effects of these arrangements, I am always careful to inform my clients that I am not a CPA and that I offer legal advice, not accounting advice. However, as a bankruptcy attorney, I can help my clients understand the laws that apply to this issue. There are several key concepts that are important to understand when you are considering any transaction that changes your arrangement with creditors. Understanding how the taxes on forgiven debts work can be complicated. There are exemptions and the debtor may receive an IRS form 1099-C, which may come as a surprise to a consumer during tax season. Basically, a creditor will issue a 1099-C when a debt of $600 or more is forgiven; it’s called a Cancellation of Debt Income that shows a debt was canceled, discharged, or otherwise forgiven. There are exclusions however.

First, you must understand how the IRS views forgiven debt. In their eyes, if a person lends you money, the IRS will not tax the money received as income because at some point, you will pay that money back. However, if the person who lent you the money agrees that you don’t have to pay it back, then the IRS considers you to have received income and they expect payment of taxes on the amount received, based on the rates that apply to you. A lender must report the forgiveness of the debt to the IRS on the 1099-C. Taxes are then calculated based on that report.

Keep in mind that just because you don’t get a 1099-C doesn’t mean that you are off the hook. If you know that you had a debt that was forgiven in the past year, you must report it. The person who lent the money may very well have filed a 1099-C with the IRS. It would be best to reach out to the lender and find out for sure.

Second, the IRS will not tax forgiven debt if the debtor is insolvent at the time that the debt is forgiven or cancelled. Being insolvent means that the amount of your debts exceeds the fair market value of all your assets.

Third, the good news for people who decide to use the bankruptcy laws as a solution, the IRS considers this to be an absolute immunity for tax liability. How better to establish that you are insolvent than by filing a bankruptcy?

Fourth, there are some obligations that are exempted from taxes. The most common are loans incurred to buy, build or substantially improve the debtor’s principal residence. Read mortgage debt. This exemption, known as the Mortgage Forgiveness Debt Relief Act, was established by a law passed by Congress when the mortgage crisis began in our country. Also, student loans that are forgiven under certain circumstances are also exempt from the taxation requirement.

To recap:

Canceled Debt that Qualifies for Exclusion from Gross Income:

1. Cancellation of qualified principal residence indebtedness.

2. Debt canceled in a Title 11 bankruptcy case.

3. Debt canceled due to insolvency.

4. Cancellation of qualified farm indebtedness.

5. Cancellation of qualified real property business indebtedness.

Canceled Debt that Qualifies for Exception to Inclusion in Gross Income:

1. Amounts specifically excluded from income by law such as gifts or bequests

2. Cancellation of certain qualified student loans

3. Canceled debt that if paid by a cash basis taxpayer is otherwise deductible

4. A qualified purchase price reduction given by a seller

Also, according to the taxpayer advocate from the IRS website, different types of debt may have different tax treatments. For example: If your debt is secured by property and the lender takes the property to fully or partially satisfy your debt, you’re treated as having “sold” that property and may have a taxable gain or loss. The gain or loss on such a “sale” is separate from any cancellation of debt income that you need to include on your return.

If you don’t report the taxable amount of the canceled debt, the IRS may send you a notice proposing to assess additional tax and may audit your tax return. In addition, the IRS may assess additional tax, penalties and interest.

Taxation on forgiveness or cancellation of debt is an important consideration for any transaction that changes the balance of a loan. This may come up in short sale transactions, mortgage loan modifications, and debt consolidation programs. Anyone considering these methods of managing their debts should seek professional advice from a consumer bankruptcy lawyer, and their CPA.

And be careful, sadly there is an entire industry today that preys of people who are overwhelmed by debt. These scammers will try to show you ways to get rid of your debt with little or no consequence; don’t call for it. Eliminating debt is not an easy process; there is no magic bullet likes a “Credit Card Debt Forgiveness Act” or an “Obama Student Loan Forgiveness Program.”

Keep in mind that some credit card companies will allow you to negotiate your debt. That is, they may reduce the balance, especially if they think you are close to bankruptcy, which in the case of a chapter 7 means they will probably get nothing. Be aware that this type of self-negotiated debt settlement, can drag out for months, will have a negative effect on your credit score, and isn’t always successful.

According to most people are better off filing for Chapter 7 bankruptcy than exposing themselves to the debt settlement process, says John Rao, attorney for the National Consumer Law Center. Bankruptcy filings halt collection actions and lawsuits, and a Chapter 7 filing can legally erase debts while ending garnishments. “All the harassing phone calls and everything else that goes on just stops,” Rao says. “It’s a fairly quick process, and the consumer gets relief immediately.”

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