When debts are canceled or forgiven, the Internal Revenue Service considers those canceled debt as taxable income. So, when the amount of a loan or mortgage is canceled or forgiven, the IRS taxes that amount as if the borrower earned it as income. But, it is important to understand that the law allows exemptions in certain situations.
If your canceled debt is subject to taxation, you will get a form 1099-C (Cancellation of Debt) from the lender showing the exact amount of the loan that was forgiven. You will fill this form with your federal tax return and the amount of the canceled debt is then added on to your gross income. However, not all canceled debt is subject to income tax. The IRS recognizes exceptions and exclusions when it comes to canceled debt.
Exceptions and Exclusions
Exceptions may include gifts or inheritances, some student loans that qualify, any paid debt that would have been a deductible item for the borrower, and certain mortgage payments under the Home Affordable Modification Program. Also, when a loan is secured by property as in the case of a mortgage where the home and land are used as collateral, then, the lender takes the property as settlement of the debt and it is considered as a sale for tax purposes, not forgiven debt. In such cases, you may need to report capital gains on the sale of the property, but you won’t need to add canceled debt to your gross income for the year.
Exclusions include debt that is canceled in a Title 11 bankruptcy or during insolvency, canceled farm debt that qualifies, canceled real property business debt and principal residence indebtedness under terms of the Mortgage Debt Relief Act. However, if you claim an exclusion, you cannot claim tax credits or capital losses.
Debt Cancellation Tips
Here are some tips if you are wondering if your canceled is subject to taxes:
- Primary residence: If your canceled debt was a loan on a taxpayer’s main home, you may be able to exclude the canceled amount from your income. In order to do that, you must have used the loan to buy, build or substantially improve your primary residence. In addition, the primary residence must secure the mortgage.
- Loan modification: If your lender canceled or reduced part of the mortgage balance through a loan modification, you may be able to exclude the amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program. Such an exclusion might also apply to a debt that was canceled as the result of a foreclosure.
- Mortgage refinancing: The amounts that were canceled on a refinanced mortgage may also get you an exclusion. However, this works only if you actually used the proceeds from the refinancing to buy, build or substantially improve your primary residence. If you used the amounts for other purposes, that does not qualify.
- Other canceled debts: Other debts such as second homes, rental and business property, auto loans and credit card debt do not qualify for this special exclusion. However, you should talk to your Arizona tax attorney about what rules might allow those types of canceled debts to be nontaxable.
- Form 1099-C: If your lender reduced or canceled at least $600 of your debt, you should receive a Form 1099-C (Cancellation of Debt). This form shows the amount of canceled debt as well as other information.
- Form 982: If you qualify, report the excluded debt on Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). It is important that you file this form along with your income tax return.
- gov tool: You can also use the Interactive Tax Assistant tool on IRS.gov to find out if your canceled mortgage debt is taxable.
Understanding the Mortgage Debt Relief Act of 2007
The Mortgage Debt Relief Act of 2007 applies only to your principal residence. It excludes as income any debt discharge up to $1 million. Provisions of the act apply to most homeowners and it includes partial debt relief gained through mortgage restructuring and full foreclosure. The Act also covers loans and other debt forgiveness for amounts borrowed to substantially improve a primary residence. You cannot use provisions of this law for other canceled debts. The Act covers debt forgiven within the calendar years of 2007 to 2016. This can also apply to debt that is discharged in 2017 provided that the written agreement was entered into in 2016. The Mortgage Debt Relief Act initially covered the period between 2007 to 2010, but was extended four times to cover subsequent years until 2016.
One More Strategy to Avoid Paying Taxes
If the tax break for principal residences does not apply to you, it is important to remember that there are two important exceptions to the rule that cancelled debt equals taxable income. The canceled debt is not income even if you receive a Form 1099-C if your debt was canceled due to a bankruptcy filing or if you are insolvent immediately before the cancellation of the debt. Insolvency essentially means that your debts exceed the value of all your assets. You can exclude cancelled debt from income up to the amount that you are insolvent. For example if you had assets of $500,000 and have debt adding up to $600,000, you are considered to be insolvent by $100,000. A knowledgeable Arizona tax lawyer can help you determine if you qualify.
Contact an Experienced Tax Lawyer
If you have just been through bankruptcy and are wondering about whether or not your canceled or forgiven dent is subject to taxes, please contact the experienced bankruptcy and tax attorneys in Mesa, AZ at The Pew Law Center, PLLC. We understand that cancelled debt can pose a significant challenge, especially if you have just been through a bankruptcy or are contemplating filing for bankruptcy. We will guide you through what can be an intimidating process and help you minimize your tax burden. Call us to find out how we can help you.