Don't Let Taxes on Forgiven Debt Take You by Surprise

In light of the severe recession, sharp decline in real estate values, and resulting high foreclosure rate, many Americans have had debt cancelled or forgiven in recent years. Unfortunately, many of them may not be aware that cancelled debt could be taxable income. Here are a few things that you should know about the tax treatment of cancelled debt.

1. Not all cancelled or forgiven debt is treated the same. Therefore, it is a good idea to talk to a tax professional about your situation before restructuring or renouncing debt so that you understand the tax implications.

2. Not all cancelled or forgiven debt is taxable. According to the Internal Revenue Service, exceptions for federal taxes are allowed for debt on a qualified principal residence (as discussed below), debt discharged through bankruptcy, insolvency (when the value of the taxpayer's liabilities exceeds the value of his assets) at the time that the debt was cancelled, some farm debt, and non-recourse loans (with terms that only entitle the lender to the property financed by the loan or property used as collateral for the loan). State tax laws concerning cancelled or forgiven debt may be different than federal laws, so be sure to check with you tax advisor about the regulations in your state.

3. Your lender is required to report cancelled or forgiven debt to the IRS and to send you a copy of a 1099-C (cancellation of debt) form that details how much debt was forgiven. This form notifies you how much debt was forgiven, not how much is taxable, which could be all, part or none of the debt included on the form.

4. The Mortgage Forgiveness Debt Relief Act of 2007 gives taxpayers a temporary reprieve from taxes on some forgiven debt on a principal residence. To qualify, among other things, the debt must be forgiven in calendar years 2007 through 2012.

5. Mortgage debt on a second home, an investment property, a rental property, or other non-primary residential real estate does not qualify for relief under the 2007 law.

6. Not all mortgage debt on a principal residence qualifies for the income tax exclusion. Only debt up to $2 million that was used to build, buy, or substantially improve a principal residence or that refinanced debt used for those purposes qualifies. Loan proceeds used for other purposes (such as a second mortgage or home equity loan on a principal residence used to buy a car or take a vacation) generally doesn't qualify for the exemption.

7. Non-mortgage debt (such as non-business credit card debt or an auto loan) does not qualify for the Debt Relief Act exemption, although it may be excluded from taxable income in the event of bankruptcy or insolvency.

8. As is probably apparent, whether income arising from loan cancellation or forgiveness is taxable is a complicated subject. Therefore, this is an area where the guidance of an experienced tax expert can be invaluable in ensuring that you pay the taxes you owe, but no more than that.

Sources

Jeff P. Opdyke, online.wsj.com, A Surprise Tax Hit on Foreclosures - WSJ.com

www.irs.gov, The Mortgage Forgiveness Debt Relief Act and Debt Cancellation