Cancellation of debt: could you be taxed on it?

In today’s troubled economic times, cancellation of debt situations are on the rise.  The big elephant in the room that a lot of people who help in these situations do not want to talk about is that this cancellation of debt could trigger some taxable income to you.  The two most common are forgiveness of home mortgage debt and forgiveness of credit card debt.

The financial institution in either of these cases will issue IRS Form 1099C for the amount of the debt that was forgiven.  Here’s a couple of situations that discuss the issues with forgiveness of these debts:

Home Mortgage –

You bought your house 10 years ago for $350,000 with a mortgage of $280,000.  Today the market value of your house is $200,000 and the mortgage balance is $250,000.  You can no longer make the monthly payments and decide to give it back to the bank.  The bank sells it for $180,000 and issues you Form 1099C in the amount of $70,000 (the difference between the mortgage balance and what the bank sold it for[$250,000 – $180,000]).

Potentially you have $70,000 of income to recognize and pay tax on this year.  You could not make the mortgage payment, how can you pay the tax of approximately $14,000?

Good news, there is a specific exclusion for the cancellation of indebtedness on your principle residence.  You may not have to pay tax on this type of debt forgiveness.  If you are in this situation contact us and we can discuss the alternatives.

Credit Card Debt –

Let’s say you have a credit card debt of $5,000 and due to changes in your employment, you can no longer make the monthly payments.  After some lengthy conversations and correspondences with the credit card company, the company decides to forgive your debt.  They issue Form 1099C in the amount of $5,000.

You now have to report $5,000 of income on your tax return.  As in the situation above, your could not pay the monthly payments but now have to pay $1,000 in income tax.

If you meet certain requirements it might be possible that this income would not be taxable.  Again, contact us if you are in this situation to discuss your options.

Going through the cancellation of debt process is scary enough.  Let us help you see if you can limit or extinguish any possible taxable income.