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Your house is foreclosed. Your car is repossessed. Your credit card balance is written off.
If you think these events hurt your credit, you’re right. But they can do more than that – they can create a giant tax bill as well.
Here’s a question I recently received from a reader…
I’m a long-time reader, but this is the first time I’ve written. I hope you can answer this question.
Like lots of people, I lost my home to foreclosure. I was recently talking to a friend of mine, and they said that even though the bank took my house back, I might have to pay taxes too. Is this true?
– Fred S.
Here’s your answer, Fred!
Unpaid debts can lead to taxable income
While borrowed money isn’t regarded by Uncle Sam as income, if you don’t pay it all back, the unpaid balance is.
Example: I loan you $10,000 and you only pay back $5,000. The day I give up trying to collect and write off the $5,000, as far as the IRS is concerned, you made $5,000. It’s the same as if you’d won $5,000 in a contest, or at a casino. In short, you’re $5,000 richer, and Uncle Sam wants his cut.
If you owe $10,000 on a credit card debt, negotiate with the credit card company and end up settling it for $5,000, same thing.
If you owe $100,000 on a mortgage, give the house back in a foreclosure and it only sells for $50,000, the bank takes a $50,000 loss. As far as the IRS is concerned, that’s $50,000 you earned.
So whenever you pay back less than you borrow, if the forgiven debt exceeds $600, you’re likely to get a 1099-C form in the mail the following January.
If you find yourself facing this misery, at least you’ll have plenty of company. According to this USA Today article, more than 6 million 1099-C’s were expected to be mailed in 2012 alone.
But don’t freak out yet: There are exceptions that may allow you to dodge this bullet.
When forgiven debt isn’t taxable
Fortunately for Fred and millions of other hapless homeowners, since 2007, forgiven foreclosure-related mortgage debt is rarely taxable.
The 2007 Mortgage Forgiveness Debt Relief Act, extended through the end of 2013, specifically excludes forgiven mortgage debt from income. At least, as long as it related to a primary residence, was less than $2 million for joint filers, and, as the IRS puts it, was “directly related to a decline in the home’s value or the taxpayer’s financial condition.”
So if the forgiven debt is home-related, you’re probably in the clear.
Here are some other situations where forgiven debt isn’t taxable:
- If the debt was discharged in bankruptcy.
- If the debt was forgiven when you were insolvent. This is the strategy used by many with canceled or settled credit card debts. You’re insolvent when what you owe exceeds what you own; in other words, your debts exceed your assets. This doesn’t mean, however, you don’t report it. The forgiveness is non-taxable only to the extent of your insolvency, and you’ll have to fill out a worksheet and file an IRS form.
- Non-recourse loans. When the lender’s only recourse is to repossess the financed property, that’s a non-recourse loan. In other words, the lender can’t come after you personally. While some real estate fits this bill, car loans almost never do.
- Some student loans can be canceled in exchange for entering certain professions or performing public service. If they meet the criteria, cancelation of these debts is non-taxable.
Note that qualifying to have your forgiven loan rendered non-taxable doesn’t make it automatic. If you get a 1099-C, so did the IRS. So if you’re entitled to an exemption, you’ll have to file a Form 982 with your tax return and prove your position.
The bottom line
The numbers involved in forgiven debt can be big, and so can the tax bill. While you can check out examples and read about it in this IRS booklet, if you get a 1099-C or otherwise think you may have to deal with forgiven debt, I’d advise enlisting the services of a tax pro. This is complicated stuff, and not an area where you want to get it wrong.
Got a money-related question you’d like answered?
Drop me a line! Just try to make sure your question would be of interest to our other readers – don’t ask for personal or super-specific advice. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.