DURING and after the recession, many borrowers who were financially distressed lost their homes and had their loans cancelled. 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. Some homeowners were in disbelief when they learn that they may owe taxes on loans that were cancelled – right after they lost their homes.
General Rule:
• You must report taxable amount of a canceled debt as ordinary income from the cancellation of debt.
• However, there are several exclusions and exceptions to this rule. These exclusions and exceptions are described below.
Exceptions: There is no cancellation of debt income from the following circumstances.
• Cancellation of debt by a private lender’s Last Will and Testament.
• Cancellation of debt by a private lender such as a relative or friend, if intended as a gift.
• Student loans for teachers, nurses, and doctors 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.
• Pay-for-Performance Success Payments that reduce the principal balance of home mortgage under the Home Affordable Modification Program.
Exclusions: There is no income from discharge of debt in the following situations:
• Insolvent taxpayer,
• Title 11 bankruptcy,
• Qualified real property business debt,
• Qualified farm debt, and
• Qualified principal residence debt (discussed below).
Qualified Principal Residence Debt Exclusion: This applies where individuals
• Lose their principal residence in a foreclosure,
• Restructure their acquisition debt on a principal residence, or
• Sell a principal residence in a short sale (where the sales proceeds are inadequate 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 financial institution, credit union, or federal government agency that pardons a debt of $600 or more.
• The amount of the cancelled 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 are not in agreement 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 sufficient documentation to show that the lender erroneously reported the amount canceled.
In accordance with IRS Circular 230, this communication is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose.
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Sy Al-os Accountancy Corporation provides accounting and tax services to individuals, corporations, LLCs and business entities. The Firm has a niche in defending taxpayers audited by the IRS and other governmental agencies.
