Tax Consequences of Settlement or Canceled Liabilities
If you settled, canceled or had consumer liabilities forgiven, you could end up owing income taxes to the IRS or your State. The IRS considers consumer liability that is settled for less, forgiven or canceled as income. Why? Well if you spent $10,000 dollars on a credit card and say $7,000 was forgiven, you received essentially $7,000 of tax-free income. There are exceptions though to this rule.
Why & How Creditors Notify the IRS of Settled, Canceled or Forgiven Debt
Your creditors (e.g. banks, credit card companies, hospitals, an auto dealership) must report any amount that is forgiven of $600 dollars or more. This typically only applies to the principal amount and not forgiven interest or penalties. The process starts whereby a creditor will notify you and the IRS with a 1099-C form after they charge off or write off your debt as noncollectable. Creditors do this to individuals who default or settle for less because they want to lower their tax liabilities. The 1099-C amount must be reported as income on your Federal tax return (if it does not meet any exceptions discussed below). Make sure that the settlement or canceled debt amount on your 1099-C is correct. Moreover, understand that a creditor normally cannot write off your debt, send you a 1099, and then sell your debt as well to a collection agency. Even if they do, you should not be held liable for the debt in most cases. The IRS also stresses that you should report any amount less than $600 on your tax return.
When Debt Settled or Forgiven Is Not Considered Income
There are a few exceptions to the IRS rule that debt settled or forgiven is considered income. In other words, just because you defaulted on a debt obligation does not mean that you necessarily will have to pay taxes on the forgiven amount. Here are a few exceptions you should know about:
Mortgage Debt Forgiveness and IRS Taxes
If part or all of your mortgage is canceled, you normally would have to pay taxes on the amount forgiven if it happened before 2007 and it was a recourse loan. A recourse loan is when the lender can pursue the borrower after the repossession if the collateral doesn’t satisfy the existing loan balance. Generally, with non-recourse loans, the lender cannot pursue the borrower after the repossession even if the collateral is not sufficient to satisfy the remaining loan balance. With a foreclosure, repossession, or abandonment on a non-recourse loan, the forgiven amount or cancellation of debt income would be equivalent to the deficiency or the difference between the outstanding mortgage balance (subtracting what the individual(s) is liable for afterwards and adding in costs and attorney fees), and what the bank sold the property for (its Fair Market Value). For tax years 2007-2009, the Mortgage Forgiveness Debt Relief Act of 2007 excludes from income any mortgage debt forgiven, and the Emergency Economic Stabilization Act of 2009 extended this exclusion through 2012 for which up to $2 million dollars (you will not have to report it as income) in forgiven debt is not taxable as long as it was your primary residence, and the debt was utilized to construct, improve, or purchase your main home. Realize, this only applies if the loan was for $2 million or less. For 2013, the Mortgage Forgiveness Act was extended through 2013 with the fiscal cliff bill.
Update: December 2014
Congress extended the mortgage debt exclusion for 2014. Recently, in December of 2015, it was extended through 2016. If you refinanced or restructured your mortgage to improve your home this qualifies for the exclusion. However, if the loan you defaulted on was used for any other purpose you will need to report the canceled mortgage debt amount as income. If you are married and filing separately, then the amount you do not have to report as income is $1 million. Realize that this exception does not apply to secondary residencies, credit card debt, or car loans. Also, be sure to check your state’s laws or loan details to figure out whether your mortgage loan is classified as recourse or non-recourse (although most loans are non-recourse). Note: This exclusion does not qualify for canceled home equity loans used to pay off credit card debt, car loans, or pay for a child’s education
You Do Not Have To Report Forgiven Debt Up to the Point of Insolvency
If you do not qualify for the mortgage debt exclusion, you may still qualify for the insolvency exclusion.
If you were insolvent before your debt was forgiven, typically you will not be held responsible for taxes. Insolvency means that your debts outweigh your assets. However, debt will only be forgiven up until the point of insolvency. For example, if you owed $25,000 on a credit card (assuming your only debt), and you had $10,000 in assets before the debt was forgiven, you were insolvent by $15,000. Therefore, if your credit card company settles with you for $5,000, you essentially saved $20,000. Therefore, you will only have to put $5,000 of the $20,000 forgiven on your tax return. To claim insolvency, use Form 982 and provide a financial statement of assets and liabilities (use the one in IRS Publication 4681) with your tax return.
Forgiven Debt Due to Identity Theft
If you accumulated debt that you were not personally liable for because your identity was stolen, you will not have to pay taxes on any forgiven amount. In fact, if a creditor sends you a 1099-C make sure you call them to correct the situation.
Certain Student Loan Debt Does Not Have To Be Reported
Sometimes certain student loans can be canceled if you work in a profession for an amount of time for “broad class of employers.” You would not have to report a canceled student loan as income if you agreed to this before the loan was given. The loan must have been given by Government, a tax-exempt public benefit corporation that has assumed control of a Government hospital whose employees are considered public employees,” or an educational institution under agreement with the former two that provided funds so it could make the loan. Even an educational institution under the direction of a 501(c)(3) or governmental entity that encourages professions in areas with “unmet needs” qualifies. The IRS code is complex here so it is best to reach out to a tax professional if you have questions.
Debt Canceled With a Chapter 11 Bankruptcy
Qualified Farm Debt That Is Canceled by a Qualified Person
Real Property Business Debt That is Canceled
Other Important Notes Regarding Taxes and Debt Settlement
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I know these facts can be tough to swallow if you have you lost a piece of property or you are up to your neck in debt. Realize the creditor has up to 3 years from the last “collection activity” to issue you a 1099-C. A creditor who has forgiven debt will issue you a 1099-C regardless of whether you have to report it as income or not. When you receive a 1099-C, report the amount in box 2, unless the interest is deductible. If the interest is deductible, report the net amount (box 2 – box 3).
If you need any help at all regarding forgiven debt you didn’t realize you had to pay taxes on, call today for a free consultation and quote in order to resolve or prevent IRS or State tax problems.