This post comes from Gerri Detweiler at partner site Credit.com.
Those who lost their home to foreclosure or sold it via a short sale in 2014 will hopefully breathe a little easier knowing that they may be able to avoid a huge tax bill when they file their tax returns.
With the passage of the “tax extenders” legislation Tuesday night by the U.S. Senate, Congress has given taxpayers one more year to exclude canceled debt from their income when filing their tax returns, as long as that forgiven debt arose from the loss or sale of their principal home.
This exclusion had expired at the end of 2013, and without the extension, some of these former homeowners could have faced massive tax bills for 2014, after suffering through financial difficulties that involved short sales or foreclosure.
For several years now, taxes on canceled debt has been a hot topic on the Credit.com blog, drawing questions and concerns from consumers around the country. For example, one Credit.com reader, Dana, is dealing with the potential loss of her home. “I am left holding the bag and am very SCARED!,” she wrote in response to a story about avoiding taxes on 1099-Cs. “What happens if I can’t pay the taxes or [insurance]. Also the thought of a 1099-C may leave me and my children on the streets.”
Taxes on ‘phantom’ income
Taxpayers are often required to pay taxes on canceled debt that is forgiven or goes unpaid for several years. When lenders cancel $600 or more in debt, they are required to file Form 1099-C with the IRS and provide the consumer with a copy of the form. The IRS then requires taxpayers to include that amount as taxable income when filling out tax returns, unless the taxpayer can demonstrate that they qualify for an exclusion or exception.
The IRS estimates that more than 5.7 million of those forms will be filed for tax year 2014, though it is unclear how many will be the result of canceled real estate debt versus credit cards or other types of consumer debt.
“Without the extension, hundreds of thousands of American families who did the right thing by short-selling their home would have to pay income tax on ‘phantom income,’” Chris Polychron, president of the National Association of Realtors, said in a written statement. “Realtors applaud Congress for passing the Mortgage Forgiveness Tax Relief Act, which will help the distressed homeowners who completed short sales in 2014.”
It’s not over yet
Consumers need to realize that this extension does not alleviate all of the headaches 1099-Cs can cause. It is wise to review IRS Publication 4681 to see if they meet the requirements to claim an exclusion.
For example, the exclusion first included in the Mortgage Forgiveness Debt Relief Act of 2007 applies to debt forgiven on principal residences only if the balance of the loan was $2 million or less. The limit is $1 million for a married person filing separately.
The exclusion applies only to mortgage debt used to acquire or improve a primary residence, so canceled home equity loans used to consolidate debt or pay for a child’s education, for example, do not qualify. Similarly, it is not available for rental properties or second homes.
Taxpayers will have to file Form 982 with their returns, and this form can be challenging to navigate, particularly when it comes to “Part II: Reduction of Tax Attributes,” which affects a narrow segment of taxpayers but can be difficult to fill out correctly without the help of a tax professional.
Consumers who cannot take advantage of the exclusion renewed by Congress may still qualify for the insolvency exclusion, which requires consumers to demonstrate they are insolvent by IRS standards. A worksheet found in Publication 4681 can be used to determine insolvency.
Taxpayers don’t need to worry that the issuance of a 1099-C will directly hurt their credit reports or credit scores. While the underlying problem, an unpaid debt, or foreclosure, for example, can affect their credit, 1099-C forms are not provided to the credit reporting agencies and will not appear on consumers’ credit reports.
However, if a 1099-C results in a large tax bill the taxpayer can’t pay immediately, the IRS may file a Notice of Federal Tax Lien, and a tax lien does appear on a taxpayer’s credit reports, significantly hurting credit scores.
Since the tax extender legislation applies only to 2014, Congress will have to revisit this issue again next year.
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