MANY financially distressed borrowers lost their homes and had their loans cancelled during and after the recession. It was a relief to have their debts reduced or forgiven, but the same debt relief also triggered tax consequences that they were not aware of. In my CPA practice as a tax consultant, homeowners express shock and disbelieve when I inform them that they may owe taxes on loans that were cancelled – right after they lost their homes. What a bummer. I just hate to be the bearer of such bad news.
General Rule:
• Tax laws specifically include income from the discharge of indebtedness in gross income.
• However, there are several exceptions and exclusions to this rule. The strategy here is to look for a way out via exceptions and exclusions described below.
Exceptions: There is no income from the following circumstances.
• Cancelation of debt by a private lender such as a relative or friend, if intended as a gift.
• Cancellation of debt by a private lender’s Last Will and Testament.
• Student loans for doctors, nurses, and teachers who agree to serve in rural or low income areas in exchange for cancellation of their student loans.
• Price adjustment if an individual purchases property and the seller later reduces the price.
Exclusions: There is no income from discharge of debt in the following situations:
• Bankruptcy,
• Insolvent taxpayer,
• Qualified farm debt,
• Qualified real property business debt, and
• Qualified principal residence debt (discussed below).
Qualified Principal Residence Debt Exclusion: This applies where individuals
• Restructure their acquisition debt on a principal residence,
• Lose their principal residence in a foreclosure, or
• Sell a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance).
Form 1099-C, Cancellation of Debt:
• A taxpayer should receive a Form 1099-C from a federal government agency, financial institution, or credit union that forgives a debt of $600 or more.
• The amount of the canceled debt should be shown in box 2.
• Any forgiven interest included in the amount of canceled debt in box 2 should also be shown in box 3.
• If you don’t agree with the amount shown on Form 1099-C, request your lender in writing to issue a corrected Form 1099-C showing the proper amount of canceled debt.
• If the lender refuses to issue a corrected report, attach to your tax return adequate documentation to show that the lender incorrectly reported the amount canceled.
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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation in Pasadena, California.
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He has 50 years of experience in defending taxpayers audited by the IRS, FTB, EDD, BOE and other governmental agencies. He is publishing a book on his expertise – “HOW TO AVOID OR SURVIVE IRS AUDITS.” Our readers may inquire about the book or email tax questions at [email protected].
