In the current economic climate foreclosures and short sales have become more commonplace. When a taxpayer negotiates with a creditor to settle his/her debt that is $600 or more, then the taxpayer should know that he/she will receive a Form 1099-C (Cancellation of Debt) from the financial entity, which may be a federal government agency, a bank, a credit union, or any organization in which a significant part of its trade or business involves the lending of money. The taxpayer should be aware of the fact that such financial institutions are required to file Form 1099-C with the IRS when a debt is forgiven. In 2010 well over three million of these forms were sent by creditors to taxpayers and the IRS.
Accordingly, this debt cancellation has to be recognized in tax returns this year.
Generally, if a debt for which a taxpayer is personally liable is canceled or forgiven, other than as a gift or bequest, the taxpayer must include the canceled amount in income. When the money was borrowed the taxpayer was not required to include the loan proceeds in income because he/she had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount received as loan proceeds is normally reportable as income because the taxpayer no longer has an obligation to repay the lender. Internal Revenue Code Section 61 defines gross income as the money constructively received by the taxpayer during the year having no obligation to repay, irrespective of its source.
When a taxpayer receives a Form 1099-C it is important not to ignore it because it could have substantial tax implications. It may create a tax liability for the taxpayer because the canceled debt is considered income for tax purposes, unless statutory exceptions apply.
The taxpayer may have the ability to reduce or eliminate this Cancellation of Debt (COD) Income, if they were insolvent immediately before the cancellation. The amount of debt forgiven must be reported on Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) and this form must be attached to the taxpayer’s tax return. Insolvent taxpayers are required to provide a statement showing their total assets and total liabilities at the point in time immediately prior to the cancellation of debt indicating that the liabilities were greater than assets.
For the purposes of completing Form 982, the IRS considers a taxpayer insolvent if the total of all of the person’s liabilities exceeded the fair-market value (FMV) of all of that person’s assets. To determine insolvency, assets include everything the taxpayer owns, e.g., car, house, condominium, furniture, life insurance policies, stocks, other investments, or pension and other retirement accounts, including assets that serve as collateral for debt and exempt assets which are beyond the reach of creditors under the law, such as interest in a pension plan and the value of a retirement account. Liabilities include the entire amount of recourse debts, and the amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.
If the taxpayer hasn’t listed the income on their tax return and the creditor has provided the information to the IRS, the taxpayer could get a tax bill or an audit notice which could end up costing a lot in terms of additional taxes, interest, and penalties. In such situation, the first thing to do is to figure out whether the taxpayer qualifies for an exclusion or exception. The most common situations when COD Income may not be taxable involve:
• Insolvency: As mentioned above, if the taxpayer is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable.
• Qualified Principal Residence Indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners. If the debt was from a mortgage on a primary residence lost in foreclosure, sold in a short sale, or from a restructured mortgage, the taxpayer still needs to include this forgiven mortgage on their tax return, but on Form 982, and shouldn’t face any tax penalty on it. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012.
Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately), as stated in IRS Publication 4681.
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income. The debt will be discharged in bankruptcy (unless the debt was incurred for business or investment purposes).
• Certain Farm Debts: If the taxpayer incurred the debt directly in operation of a farm, more than half the taxpayer’s income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, the cancelled debt is generally not considered taxable income.
• Non-Recourse Loans: A non-recourse loan is a loan for which the lenders only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue the taxpayer personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure should not result in COD Income. However, it may result in other tax consequences.
• Student Loans. Student loans forgiven by an educational institution that is tax-exempt are exempt if the taxpaper works for a certain number of years for a qualified employer. The taxpayer’s student loan cancellation will not result in taxable income if they agreed to a loan provision requiring him/her to work in a certain profession for a specified period of time, and they subsequently fulfilled this obligation. Additionally the student loan must have been made by (a) the federal government, or a state or local government or subdivision; (b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or (c) a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.
The Internal Revenue Service Publication 4681 contains more information on the tax consequences of canceled debt. It also contains specific instructions on how to complete Form 982. When a taxpayer receives a 1099-C, it should be kept with the taxpayer’s tax documents. Be it noted that such document should be made available to the tax preparer and provide the tax preparer with information regarding the taxpayers total liabilities and the FMV of assets as they were immediately before the cancellation of debt.
State tax laws for cancelled debts may differ from that of federal tax law. When in doubt, consult a tax professional to help determine the tax consequences of COD Income.
The tax information contained in this article is of a general nature and should not be acted upon in your specific situation without further details and/or professional assistance.
Khorshed Alam is a practicing CPA and Business Valuation Analyst. Check out http://alamcpatax.com or call (408) 445-1120.