If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable. This type of debt includes mortgages, credit cards, car loans and student loans. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form. If you disagree with the amount reported contact your lender to work out any discrepancies and have them issue a corrected Form 1099-C.
The Mortgage Debt Relief Act of 2007 generally allows you to exclude income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing separately.
Taxpayers must complete Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to report the exclusion of forgiveness of qualified principal residence indebtedness and attach it to their tax return. The cancellation of debt on a second home, credit card, car loan or student loan cannot be excluded from income under this provision and would generally be included in income on your tax return. But, there are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
- Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default.
The cancellation of student loan debt will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation. Below are the other conditions when you can exclude the cancellation of student debt from income; The student loan must have been made by:
- the federal government, or a state or local government or subdivision;
- a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or
- a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.
ACTION ITEM: Cancellation of debt is a complicated issue and can have a significant tax impact. If you have had debt forgiven in 2011, consult with your CPA on your specific situation.
Tom Scanlon has over thirty years experience in public accounting with an extensive background in the areas of financial, tax, and estate planning. He prides himself on providing in-depth and customized solutions to privately held businesses and their owners. He is a Certified Public Accountant and Certified Financial Planner®. Tom is a frequent speaker for area organizations and has recently been quoted on CNBC, Fox 61 News and AARP's blog. Tom also has been a guest columnist for numerous publications including The Wall Street Journal, Barron's, Money Magazine, The Hartford Courant, The Hartford Business Journal, and The New Haven Register. He is a member of the American Institute of Certified Public Accountants, the Connecticut Society of Certified Public Accountants, and the Financial Planning Association. Active in the community, Tom supports a variety of not-for-profit organizations.
The exception to the rule regarding non-recourse loans does not appear to apply to home loans exclusively. Have I misenterpretted that clause or can it apply to an apartment building?
Can you provide the specific tax code dealing with this issue?
Thank you
Bob,
Good question. This is a very complex area.
Yes, I believe your interpretation is correct.
Here are some sources for you:
IRS Publication 544 – Sales and Other Dispositions of Assets
IRS Publication 4681 – Canceled Debts, Foreclosures, Repossessions and Abandonments
IRS Code Section 108
I hope this helps.
Tom