Thrifty Spending Issue 65

FEATURE ARTICLE: Forgiven debt such as credit card settlements can trigger a tax bill

Getting a tax bill after you’ve gone through foreclosure is like having a bucket of ice water poured over your head after someone has made off with your pants. You’ve lost your home and probably don’t have much money, so why would you owe the IRS anything?

Here’s why: The IRS treats forgiven or canceled debt as taxable income.

For example, suppose you owe $400,000 on a home that goes into foreclosure, the bank sells it for $300,00 and writes off the rest of your loan. Under the tax code, the $100,000 in forgiven debt is taxable income.

In 2007, Congress enacted legislation that excludes up to $2 million in forgiven mortgage debt from taxes, as long as the loan was used to buy or improve the taxpayer’s primary residence. That means most people who lost their homes to foreclosure last year won’t have to pay taxes on the canceled debt, says Robin Christian, tax analyst for Thomson Reuters.

There are limits, though, to this relief. The exclusion is scheduled to expire at the end of 2012, which means homeowners who are starting to fall behind on their payments could face a nasty tax surprise in 2013. And individuals who have had other types of debts forgiven by their lenders could be in trouble right now.

Financial institutions that write off debt of $600 or more are required to send a Form 1099-C to the borrower and the IRS.

If you receive a 1099-C for debt that was forgiven as a result of a foreclosure, you need to inform the IRS that it qualifies for the exclusion, Christian says. To do this, fill out Form 982 on your Form 1040 and check Part I, box 1E.

Otherwise, the IRS may treat your forgiven debt as taxable income.

And there’s plenty of forgiven debt that falls into that category, including:

• Credit card debt. In recent years, some borrowers who have no chance of paying off their credit card debts have persuaded their lenders to settle for a reduced amount. These agreements could put an end to calls from collection agencies, but they could be replaced by calls from the IRS.

• Student loans. Getting a student lender to write off some of your debt is extremely difficult, but should you succeed, the amount of forgiven debt may be taxable, says Gil Charney, principal tax researcher for H&R Block’s Tax Institute. However, there’s an important exception: If your debt was forgiven because you worked for a specific number of years in your profession, it probably isn’t taxable, he says. For example, doctors who agree to work in rural areas in exchange for loan forgiveness don’t have to pay taxes on the canceled debt, Charney says.

To find out whether you’re eligible for this exclusion, read the provisions of your loan or talk to your lender.

• Mortgage debt from a second home. If you lose a vacation home or rental property to foreclosure, any forgiven debt is taxable, Charney says.

• A second mortgage or home equity line of credit that wasn’t used to improve your home. If you took out a home equity line of credit to update your kitchen, forgiven debt on that loan is excluded from tax, Charney says. However, a home equity line of credit that was used to pay for a vacation or child’s college tuition doesn’t qualify for the exclusion.

And remember, the exclusion for mortgage debt will expire at the end of 2012, unless Congress votes to extend it. Since foreclosures can sometimes drag out for months, homeowners who are facing the loss of their homes may want to take steps to complete the deal before the end of 2012, Charney says.

Other exceptions

Even if your forgiven debt doesn’t qualify for an exclusion, taxes aren’t inevitable. Individuals facing tax bills on forgiven debt have two options:

• File for bankruptcy. Debt that’s canceled as the result of bankruptcy proceedings isn’t taxable, Charney says.

• Prove insolvency. The IRS will reduce or eliminate taxes on forgiven debts if you can demonstrate that you’re insolvent. To do this, though, you must convince the IRS that your debts exceed the fair market value of everything you own.

If all you own is a car and a savings account, proving insolvency may be straightforward, Christian says.

But if you’re like most families, you own other assets, such as retirement savings, jewelry and life insurance policies.

“It’s not an easy calculation,” Christian says. “Someone who thinks they are insolvent ought to contact a professional.”

By Sandra Block @

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