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1. What is Cancellation of Debt?
If you borrow money from a
commercial lender and the lender later cancels or
forgives the debt, you may have to include the cancelled
amount in income for tax purposes, depending on the
circumstances. When you borrowed the money you were not
required to include the loan proceeds in income because
you had an obligation to repay the lender. When that
obligation is subsequently forgiven, the amount you
received as loan proceeds is reportable as income
because you no longer have an obligation to repay the
lender. The lender is usually required to report the
amount of the canceled debt to you and the IRS on a Form
1099-C, Cancellation of Debt.
Here’s a very simplified example.
You borrow $10,000 and default on the loan after paying
back $2,000. If the lender is unable to collect the
remaining debt from you, there is a cancellation of debt
of $8,000, which generally is taxable income to you.
2. Is Cancellation of Debt
income always taxable?
Not always. There are some
exceptions. The most common situations when
cancellation of debt income is not taxable involve:
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Bankruptcy: Debts discharged through bankruptcy are
not considered taxable income.
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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.Insolvency can be fairly complex to
determine and the assistance of a tax professional
is recommended if you believe you qualify for this
exception.
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Certain farm debts:If you incurred the debt directly
in operation of a farm, more than half your income
from the prior three years was from farming, and the
loan was owed to a person or agency regularly
engaged in lending, your cancelled debt is generally
not considered taxable income.The rules applicable
to farmers are complex and the assistance of a tax
professional is recommended if you believe you
qualify for this exception.
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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.Forgiveness of a
non-recourse loan does not result in cancellation of
debt income.However, it may result in other tax
consequences, as discussed in Question 3 below.
3. I lost my home through
foreclosure. Are there tax consequences?
There are two possible consequences
you must consider:
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Taxable cancellation of debt income.(Note: As stated
above, cancellation of debt income is not taxable in
the case of non-recourse loans.)
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A reportable gain from the disposition of the home
(because foreclosures are treated like sales for tax
purposes).(Note: Often some or all of the gain from
the sale of a personal residence qualifies for
exclusion from income.)
Use the following steps to compute
the income to be reported from a foreclosure:
Step 1 - Figuring
Cancellation of Debt Income (Note: For
non-recourse loans, skip this section. You have no
income from cancellation of debt.)
1. Enter the total amount of the
debt immediately prior to the foreclosure.___________
2. Enter the fair market value of the property from Form
1099-C, box 7. ___________
3. Subtract line 2 from line 1.If less than zero, enter
zero.___________
The amount on line 3 will generally
equal the amount shown in box 2 of Form 1099-C.
This amount is taxable unless you meet one of the
exceptions in question 2. Enter it on line 21,
Other Income, of your Form 1040.
Step 2 – Figuring Gain from
Foreclosure
4. Enter the fair market value of the property
foreclosed.For non-recourse loans, enter the amount of
the debt immediately prior to the foreclosure ________
5. Enter your adjusted basis in the
property.(Usually your purchase price plus the cost of
any major improvements.)
____________
6. Subtract line 5 from line 4. If less than zero,
enter zero.
The amount on line 6 is your gain
from the foreclosure of your home. If you have
owned and used the home as your principal residence for
periods totaling at least two years during the five year
period ending on the date of the foreclosure, you may
exclude up to $250,000 (up to $500,000 for married
couples filing a joint return) from income. If you
do not qualify for this exclusion, or your gain exceeds
$250,000 ($500,000 for married couples filing a joint
return), report the taxable amount on Schedule D,
Capital Gains and Losses.
4. I lost money on the
foreclosure of my home. Can I claim a loss on my
tax return?
No. Losses from the sale or
foreclosure of personal property are not deductible.
5. Can you provide examples?
A borrower bought a home in August
2005 and lived in it until it was taken through
foreclosure in September 2007. The original purchase
price was $170,000, the home is worth $200,000 at
foreclosure, and the mortgage debt canceled at
foreclosure is $220,000. At the time of the
foreclosure, the borrower is insolvent, with liabilities
(mortgage, credit cards, car loans and other debts)
totaling $250,000 and assets totaling $230,000.
The borrower figures income from
the foreclosure as follows:
Use the following steps to compute
the income to be reported from a foreclosure:
Step 1 - Figuring
Cancellation of Debt Income (Note: For
non-recourse loans, skip this section. You have no
income from cancellation of debt.)
1. Enter the total amount of the
debt immediately prior to the foreclosure.___$220,000__
2. Enter the fair market value of the property from Form
1099-C, box 7. ___$200,000__
3. Subtract line 2 from line 1.If less than zero, enter
zero.___$20,000__
The amount on line 3 will generally
equal the amount shown in box 2 of Form 1099-C.
This amount is taxable unless you meet one of the
exceptions in question 2. Enter it on line 21,
Other Income, of your Form 1040.
Step 2 – Figuring Gain from
Foreclosure
4. Enter the fair market value of
the property foreclosed.For non-recourse loans, enter
the amount of the debt immediately prior to the
foreclosure. __$200,000__
5. Enter your adjusted basis in the
property.(Usually your purchase price plus the cost of
any major improvements.)
___$170,000__
6. Subtract line 5 from line 4.If less than zero, enter
zero.___$30,000__
The amount on line 6 is your gain
from the foreclosure of your home. If you have
owned and used the home as your principal residence for
periods totaling at least two years during the five year
period ending on the date of the foreclosure, you may
exclude up to $250,000 (up to $500,000 for married
couples filing a joint return) from income. If you
do not qualify for this exclusion, or your gain exceeds
$250,000 ($500,000 for married couples filing a joint
return), report the taxable amount on Schedule D,
Capital Gains and Losses.
In this situation, the borrower has
a tax-free home-sale gain of $30,000 ($200,000 minus
$170,000), because they owned and lived in their home as
a principal residence for at least two years.
Ordinarily, the borrower would also have taxable
debt-forgiveness income of $20,000 ($220,000 minus
$200,000). But since the borrower’s liabilities exceed
assets by $20,000 ($250,000 minus $230,000) there is no
tax on the canceled debt.
Other examples can be found in IRS
Publication 544, Sales and Other Dispositions of Assets,
under the section “Foreclosures and Repossessions”.
6. I don’t agree with the
information on the Form 1099-C. What should I do?
Contact the lender. The
lender should issue a corrected form if the information
is determined to be incorrect. Retain all records
related to the purchase of your home and all related
debt.
7. I received a notice
from the IRS on this. What should I do?
The IRS urges borrowers with
questions to call the phone number shown on the notice.
The IRS also urges borrowers who wind up owing
additional tax and are unable to pay it in full to use
the installment agreement form, normally included with
the notice, to set up a payment agreement with the
agency.
Copyright 2007, The Dave Madam Real Estate Team
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