Why Will You Owe Taxes If You Settle Liabilities or Become Unemployed?

Many Americans, believe it or not, who become unemployed or settle liabilities can be stuck with a State and/or Federal tax bill. It seems crazy that anyone facing such financial difficulties would be asked to pay taxes but this happens for many reasons.

Unemployment Compensation

There are many ways you could end up paying owing more taxes than you thought when you file this year.  Under the American Recovery and Reinvestment Act, the first $2,400 of compensation is tax-free for an individual (married or not). With unemployment, you can elect to have your taxes taken out or you can choose not to since unemployment compensation is taxable. Federal law requires that individuals who left the workforce have the option of taxes being withheld from unemployment benefits. Many states offer the same choice, but some just do not withhold taxes or tax unemployment income at all (like California). You should be mailed Form 1099-G, which will show how much unemployment compensation you received.

Canceled or Settled Liabilities

Creditors must report liability that is forgiven over $600 to the Internal Revenue Service and to you (you should receive a 1099-C). The amount forgiven must be part of the principal as interest or penalties received would not constitute income. The IRS looks at this forgiven amount as income and will expect you to pay taxes on the amount in most cases. There are a few exceptions though.

• Insolvency – If you are deemed insolvent before your liability was forgiven or settled you usually will not be liable to pay taxes on the canceled liability amount. Insolvency mean your liabilities are greater than your assets. To figure out what you have to report on your tax return you must first calculate your insolvency amount. For example, if you owe $40,000 in credit card liabliity, and have $30,000 in assets, you are insolvent by $10,000. If your creditor cancels $12,000 in credit card liabilities you will have to report $2,000 in income on your tax return. To prove insolvency you will use Form 982 and attach it to your tax return along with a financial statement that illustrates your assets (fair market value) and liabilities at the time of settlement. Keep in mind, State laws differ on this issue so be sure to check your state or call a state tax representative.
• Real Estate – With a foreclosure, taxes are normally owed on the deficiency amount which can be defined as the difference between what your mortgage balance was and what the lender sold the property for. If you foreclosed on your home you, and it was your primary residence, you will not be held liable for the taxes (up to $2M) because of the Mortgage Forgiveness Liability Relief Act of 2007 (extended to 2012).   However, if the property was not your primary residence (a vacation home) or you defaulted on a loan that was secured by your home but not used for home improvement you will be liable for taxes–unless at the time of the default you are insolvent of course.

If you fail to report canceled liabilities you will ultimately owe back taxes or have tax liabilities. In this case, you will end up receiving IRS letters and/or potentially an Internal Revenue Service audit which means you could incur tax interest and penalties. In many cases, the negative consequences of failing to deal with forgiven liabilitiy can outweigh the original benefit of having it canceled.

If you are already a victim of these unfortunate tax laws related to unemployment or settlement, and you owe back taxes, sign up for a free consultation today.

What do you think of these negative tax consequences associated with unemployment and canceled liabilities? Feel free to comment below.