Cancellation of debt may be a wonderful thing for you, your family, or your business. Oftentimes, your debt may be forgiven if you have defaulted on a loan, and can show ample evidence that you are not able to keep up with payments. After you have completed the necessary steps toward Debt Forgiveness on your defaulted loan, you will receive a Form 1099C- Cancellation of Debt from your lender. But it is important to know you are not necessarily “in the clear,” once your debt is forgiven.
This article is geared toward those of you who have received a Form 1099C-Cancellation of Debt on a defaulted loan. Its goal is to help you figure out if you owe taxes on the Forgiven Debt. There is a good chance you owe taxes you may not have been aware of previously. Read on to learn about the rules and exceptions of taxable debt forgiveness.
It is important to know that once your commercial lender cancels or forgives your debt, it does not magically disappear. Oftentimes, this debt owed turns into taxable income, meaning the “debt” becomes “income,” and you will owe taxes on it just like any other income you earned that year.” Let’s take a closer look at why this happens.
When you borrow money from a lender, you are not required to include the loan money as income on your tax return because you are signing an obligation to repay the lender all of the money. If, for numerous reasons, you need your debt cancelled or forgiven, you are now stating that you will never repay the loan money. This automatically turns the money you were lent into money you received. As this was not a “gift” for tax purposes, this money turns into “income earned.” Because of this, when your debt is forgiven or cancelled, the money left on the loan may be categorized as income and may be taxable on your next yearly tax return. The lender is required to report the amount of canceled debt to you and the IRS on a Form 1099C- Cancellation of Debt. You receive this form, and so does the IRS.
The IRS provides a simple example on its website. If you borrow $10,000 and default on the loan after paying back $2,000, the lender is unable to collect the remaining debt from you. There is a cancellation of debt of $8,000, which is generally taxable income to you at this point. This will be reported on the Form 1099C-Cancellation of Debt to you and the IRS.
Like many rules, there are exceptions to this one. There are common situations when the cancellation of debt income is not taxable. These include:
2. Insolvency: (You are insolvent when your total debts are more than the fair market value of your total assets.)
3. Certain farm debts
4. 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 resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences, see below.)
If your situation involves one of these exceptions, it is important that you hire a tax expert immediately to help you prove your case to the IRS. These matters can be very complicated, and you do not want to attempt gathering necessary information on your own if you are not very skilled at handling cases with the IRS. Debt forgiven on a home due to foreclosure may also be a different exception. Read below to learn more.
If your home mortgage was a non-recourse loan, your bank will repossess the property and there will be no taxable income to report. In other situations, you may owe taxes on a home foreclosure. We have conveniently placed the quick calculator for figuring out your cancellation of debt income below*. Fill in your figures on the blank lines in order to see what taxable income you may be required to report to the IRS.
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 1099C. This amount is taxable unless you meet one of the exceptions listed above. This amount is also to be listed in line 21, Other Income, of your Form 1040. If you owe more than the fair market value of your foreclose property, you will most likely owe taxes on the foreclosure. If you owe less on your property than its fair market value, you will most likely not owe taxes on the foreclosure.
You have received Debt Forgiveness from your lender, and have even received the Form 1099C- Cancellation of Debt form. It is important you are educated on what happens next, in order to avoid tax fraud, and incur even more penalties due to late filing or payment. If you do not meet the exceptions listed above, the amount of debt forgiven may become taxable income that you are obligated to report on your next tax return.
If your situation includes an exception, Bankruptcy, Insolvency, Certain Farm Debts, or Non-Recourse Loans, it is important that you contact a Certified Public Accountant immediately, since these situations are involved and complicated. A tax expert can inform and guide you out of a hole, and stop you from digging an even deeper one. Set up your free Debt Forgiveness/ Form 1099C- Cancellation of Debt consultation with Acosta Tax and Advisory experts today by calling 954-674-0076, or schedule your free consultation on our website at www.mycpa.net.
*Form taken directly from www.irs.gov