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To Forgive or not to forgive: That is the question?
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In this tough economy, some consumers are working out debt forgiveness plans with Credit Card and mortgage companies. These circumstances can result in the lender assuming some or all of the monies owed by the consumer.
In the case of credit card debt, say Mr. Smith charged his Hawiian Vacation on a Credit Card. Then Mr. Smith can no longer pay his credit card company because he lost his high paying job. He negotiated a deal with the credit card company and they forgave $5,000 of his debt. Mr. Smith may think he is done paying. According to the IRS – not exactly. The debt is now considered income since the consumer never paid the debt back. So don’t be surprised to see a “1099-C, Cancellation of Debt” form in the mail around tax season. Since these monies are considered income it will be taxed as income!
The same situation occurs in a “Short Sale” or “Foreclosure”. A short sale is when a bank sells your house for less than what is owed and the debt is forgiven. An example would be if a home sells for $250,000 and $300,000 is owed on the loan, then $50,000 would be forgiven. Unfortunately the forgiven amount may be taxed and a 1099-C would be issued. The situation would be the same in a Foreclosure situation except the sale price would be compared to the Fair Market Value of the home. However, there are new laws that may help the above situations see below.
There is still hope for those in dire circumstances to avoid paying some if not all of taxes owed on the cancellation of debt.
1. If Bankruptcy is declared.
2. The Mortgage Forgiveness Debt Relief Act of 2007: (as stated by the IRS, says "This Act applies only to forgiven or canceled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing separately."
3. If you prove insolvency then debt up to the amount that individual(s) are insolvent is forgiven. What is the definition of insolvency: in laymans’ terms this means Liabilities minus Assets; and liabilities must exceed the assets amount. So if Dick and Jane were $50,000 in debt and only had $20,000 in assets then they would be $30,000 insolvent. If they had $40,000 of credit card debt forgiven….then they would still owe $10,000 income in taxes….$40,000 - $30,000 =$10,000.
4. Midwestern disaster area indebtedness.
5. Qualified Farm indebtedness.
6. Qualified real property business debt.
7. Qualified principal residence indebtedness.
As most circumstances vary regarding Cancellation of Debt it is important to research all variables to produce the best outcome. Further research can be found through the IRS website here, as well as here.
If you are unclear about your circumstances it may be in your best interest to contact a professional tax preparer. Always remember to have backup documentation for all figures in case of an audit. The IRS has the right to audit anyone at anytime so don’t throw away any documentation!
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