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When the economy is down and debts begin to pile up, creditors have a few options in order to obtain the amount that is owed to them: (1) send the debt to collections and potentially receive only a partial amount for what they are owed; (2) attempt to collect the debt by taking the debtor to court and obtaining a judgment for the owed amount; or (3) partially or fully forgiving the debt and writing off the debt on their financials.
Unfortunately for debtors, they do not get to participate in the creditors’ decision-making process as to how to collect the debt. Thus, debtors are often stuck dealing with collection agencies or being summoned to court. However, sometimes a debtor may celebrate because his or her creditor has decided to forgive and write off the debt. Although, the debtor’s euphoria will likely fade quickly when he or she realized that debt forgiveness may trigger a tax liability. Debt forgiveness does not necessarily mean that everything is forgotten in the eyes of the Internal Revenue Service.
Generally, when recourse debt is forgiven or canceled, then the taxpayer must include that amount in their income as long as the cancellation or forgiveness was not a gift or bequest.
When a taxpayer borrows money, the taxpayer is not required to report the loan proceeds in his or her income because the taxpayer still has an obligation to repay the loan. However, when that loan is canceled or forgiven, the taxpayer has essentially received free money and should report the forgiven or canceled loan proceeds as income because the taxpayer no longer has the obligation to repay the loan.
When a creditor forgives or cancels a debt, the creditor typically provides a Form 1099-C, Cancellation of Debt to the debtor by January 31 and to the IRS by February 28th (or March 31 if e-filing) of the subsequent tax year following the tax year in which the cancellation of debt occurred. The amount of the debt that is forgiven or canceled will be reported in Box 2 of Form 1099-C.
For example, Mr. Smith borrows $10,000 from Bank. After paying back $2,000, Mr. Smith defaults on the loan in July of 2010. Bank then decides to forgive the remaining debt that Mr. Smith owes. Therefore, there will be a cancellation of debt in the amount of $8,000 which will generally be taxable to Mr. Smith in the 2010 tax year. Bank will issue a Form 1099-C in the amount of $8,000.
There are some exceptions to the general rule. If a taxpayer falls under one of these exceptions, then the taxpayer will not be taxed on his or her cancellation of debt. Some of the common exceptions are:
If a taxpayer receives a Form 1099-C due to a cancellation or forgiveness of a debt and the taxpayer satisfies one of the exceptions, then the taxpayer should file Form 982 with his or her federal income tax return for the tax year in which the debt was canceled or forgiven.
Qualified Principal Residence Indebtedness
Internal Revenue Code §108(a)(1)(E), which was added to the Code by the Mortgage Forgiveness Debt Relief Act of 2007, allows an exclusion of income realized as a result of a modification of the terms of a mortgage, a mortgage restructuring, or a foreclosure on a taxpayer’s principal residence.
In order to meet this exclusion, the taxpayer must satisfy these four requirements:
If only a portion of the loan discharged is qualified indebtedness, the exclusion for qualified principal residence indebtedness applies only to the extent the amount of debt discharged exceeds the amount of the loan (immediately prior to the cancellation) that is not qualified indebtedness.
In order to determine if a home foreclosure results in cancellation of indebtedness income, a taxpayer must subtract the fair market value of the property from the debt that was cancelled. If the debt cancelled exceeds the property's fair market value, then the taxpayer has realized income from the debt cancellation and may receive a Form 1099-C.
A taxpayer is not required to include in their taxable income any amount of canceled or forgiven debt if the taxpayer was insolvent immediately prior to the cancellation or forgiveness. A taxpayer is considered to be insolvent if the total of the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets.
The taxpayer’s assets include everything the taxpayers owns, including assets that serve as collateral for debt and exempt assets which are beyond the reach of a creditor under law, such as a pension plan or retirement account. The taxpayer’s liabilities include all recourse debts and the amount of nonrecourse debt that is not in excess of the fair market value of the property that is security for the debt.
In some instances a taxpayer’s debt may be forgiven that was incurred to attend a qualified educational institution if the taxpayer works for a certain period of time in a certain profession for a certain employer. In this situation, the taxpayer will not have taxable income due to their cancellation of debt as long as the student loan is canceled after the taxpayer agreed to the student loan and performed the required services.
An eligible educational institution is an organization with a regular faculty and curriculum and a regularly enrolled body of students in attendance at the place where the educational activities are carried on.
However, a taxpayer will be taxed on their cancellation of debt from their student loan if the loan was made by an educational institution and is canceled because of services the taxpayer performed for the institution or other organization that provided the funds.
A recourse debt is any debt in which the taxpayer is personally liable. All other debt is nonrecourse debt.
Generally, a taxpayer does not include in their income any canceled debt if the debt is nonrecourse debt. However, the amount of nonrecourse debt that is satisfied from a foreclosure on the taxpayer’s property is generally treated as proceeds from the sale of the property. This treatment may result in taxable gain to the taxpayer.
When a property’s nonrecourse debt is in excess of the fair market value of the property, then the entire amount of the nonrecourse debt is treated as an amount realized on the disposition of the property. Any gain or loss on the disposition of the property is determined by the difference between the total amount realized and the taxpayer’s adjusted basis in the property. The character of the gain or loss on the disposition of the property is determined on the basis of the character of the foreclosed property.
Taxpayers who have property that is foreclosed on may receive a Form 1099-A by their lender. Property that is foreclosed on or repossessed is generally treated as a sale of the property and the taxpayer may have to report a taxable gain due to the foreclosure or repossession.
If a lender forecloses or repossesses a property and cancels or forgives the debt in the same calendar year, then the lender has the option of issuing a Form 1099-A and a Form 1099-C or combining all of the information solely on a Form 1099-C only.
For more information on debt cancellation, foreclosures, and repossessions please see IRS Publication 4681, IRS Publication 523, and IRS Publication 544.
About the Author
Camron L. Hoorfar is admitted to practice law in the state of Missouri and before the United States District Court for the Western District of Missouri. Camron is also admitted to practice in the state of Kansas and before the United States District Court for the District of Kansas.