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 this type of 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, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 35th anniversary this year. You may email tax questions to Vic at [email protected]. You are welcome to visit our website for more than 300 tax tips at www.victorsycpa.com.