Beware of the IRS If Your Creditor Writes Off or Settles a Debt
As more and more people are finding their sub-prime mortgage rates rise rapidly, a record number of foreclosures and short sales are occurring. A short sale is a great tool for many people experiencing hardship, however most people don't realize there are tax implications. We like to prepare our clients for everything they may encounter, so they can be fully prepared. For more information on how a short sale can be conducted, or what other options are available, please feel free to contact us directly. We advise all of our clients to consult with their accountant or tax attorney to fully understand how saving their credit through a short sale will impact their tax liability.
From the Nolo.com Debt & Bankruptcy Center
The IRS may count a debt written off or settled by your creditor as income to you.
An IRS regulation could cost you money if you settle a debt with a creditor. This rule may also shrink your wallet if a creditor writes off money you owe -- that is, ceases collection efforts, declares the debt uncollectible and reports it as a tax loss to the IRS. (26 U.S.C. § 108.) Debts subject to this regulation include money owed after foreclosure, property repossession or on a credit card bill you don't pay.
Under the IRS regulation, any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for the report of income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income.
There are five exceptions stated in the Internal Revenue Code, three of which apply to consumers. So even if the financial institution issues a Form 1099-C, you do not have to report the income on your tax return if:
- the cancellation or write off of the debt is intended as a gift (this would be unusual)
- you discharge the debt in bankruptcy, or
- you were insolvent before the creditor agreed to settle or write off the debt.
The Internal Revenue Code does not define what is meant by insolvent. Generally, it means that your debts exceed the value of your assets. Therefore, to figure out whether or not you are insolvent, you will have to total up your assets and your debts, including the debt that was settled or written off.
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Examples
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Example 1: Your assets are worth $35,000 and your debts total $45,000. You are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.
Example 2: This time your assets are still worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don't have to report $10,000 of the income, but you will have to report $4,000 on your tax return.
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If you conclude that your debts exceed the value of your assets, include IRS Form 982 with your tax return. You can download the form off the IRS's website at www.irs.ustreas.gov/forms_pubs/forms.html. Completing it is simple.
If your debts are enormous and your bank or other financial institution is willing to settle for less than you owe, it could cost you a lot in the end. Before accepting what sounds like a deal, have a tax preparer calculate your tax liability. If your tax bill will be too high and you cannot prove you are insolvent, you may be better off filing for bankruptcy and discharging the entire debt, if possible.
If you plan to file for bankruptcy and want to include a debt that a creditor has settled or written off, talk to a bankruptcy lawyer -- preferably one who knows tax law. Some lawyers have concluded that on the day the creditor settles or writes off a debt, a "taxable event" occurs. This means that if you file for bankruptcy after that date, you cannot wipe out the debt unless your tax debt could be wiped out in bankruptcy. Other lawyers feel that the taxable event occurs on April 15, when your taxes are due, and that you can file for bankruptcy and wipe out the debt before that date, assuming it otherwise qualifies to be eliminated in bankruptcy.
Finally, bear in mind this fact: even if you don't get a Form 1099-C from a creditor, the creditor may very well have submitted one to the IRS. You can take the risk that the creditor did not pass the information on to the IRS and "forget" to list the income when you file your tax return. But if the IRS has the information, it will send you a tax bill, or worse, an audit notice, which could end up costing you more -- because of IRS interest and penalties -- in the long run.
