Cancellation of Indebtedness: Income Tax Issues and Planning
Short Sales and Foreclosures
If you have had a cancellation of a debt, a short sale, or a foreclosure on your home, you face special tax issues. At Koontz & Associates, PL, we routinely handle these procedures and the unique tax implications they present. Debt forgiveness may result in harsh tax consequences, which may be reduced or eliminated with proper planning.
Cancellation of Debt
Lenders who release a borrower from an outstanding loan are required to issue a Form 1099-C which reports the cancellation of debt. Although the borrower is not receiving cash, the IRS considers the extinguished debt obligation to be taxable income. This includes mortgage lenders and even credit card companies.
For example, if the seller borrowed $300,000, the lender receives $200,000 in proceeds from a short sale and forgives the remaining $100,000 balance; the IRS’ position is that the seller has $100,000 of income that no tax has been paid on. The IRS does not consider that the loan proceeds were “spent” on a property which has lost value. The result is phantom income, meaning that the seller has not received cash from the sale proceeds with which to pay the tax. The amount of debt forgiven by lenders, particularly in short sales, can be substantial, and may result in unexpected taxable income and higher tax rates.
Cancellation of debt income can cause complications to the seller’s tax return. Although one may traditionally fall into a lower tax bracket, cancellation of debt may substantially increase a seller’s taxable income and their total income could be taxed at a higher tax rate. It is not uncommon to see as much as $150,000, or more, granted in debt forgiveness which could easily result in a higher tax rate for many borrowers.
Reducing Tax on Cancellation of Debt Income
The Internal Revenue Code provides an insolvency exclusion which exempts forgiven debt for a taxpayer, to the extent of their insolvency. Insolvency is the difference between the taxpayer’s outstanding liabilities and the fair market value of all assets held on the date of sale or debt forgiveness. However, a borrower should never assume that they qualify for this exemption by virtue of the fact that there is negative equity in their home. To determine eligibility for the insolvency exclusion, a detailed analysis of a taxpayer’s assets and liabilities would need to be performed.
Lenders are required by law to report on Form 1099-C any release of debt greater than $600 and have no discretion to withhold such information. The resulting tax liability occurs upon the release of loan obligation, not upon the issuance of the 1099-C. Not only does the lender have a reporting obligation, but the borrower must also report this liability on their tax return for that year. Failure to do so can result in a 25% underreporting penalty and an increased audit period from three to six years.
Some borrowers believe that foreclosure may allow them to circumvent tax liability, but release of debt may occur following completion of a foreclosure. In addition, this may happen without the borrower even knowing it, until they receive the 1099-C from the lender. Again, the borrower has no ability to request the lender not issue the 1099-C, and if the lender chooses to release the debt following the foreclosure action, either on its own accord or in response to post-deficiency negotiations, the debt forgiven will likely be much larger and the incidental tax liability much greater due to the additional costs and fees that accumulate and grow on the balance of a loan throughout a foreclosure action.
Borrowers also believe bankruptcy to be a potential solution to tax liability. This may be accurate depending upon when the borrower files bankruptcy. Income tax liability is not typically dischargeable particularly if the forgiveness of debt occurs prior to the bankruptcy filing.
The Importance of Tax Planning Prior to a Short Sale or Foreclosure
Tax consequences resulting from short sales, debt settlement, loan modifications, and foreclosures are fact specific and should always be evaluated by a professional. In many cases, tax planning can help a seller legally avoid or minimize the tax consequences of their transaction. If the seller proceeds without planning for the tax impact of the transaction, they are often unpleasantly surprised with the outcome.
Call Koontz & Associates, PL for a Review of Your Debt Forgiveness Tax Issues
Jo Ann M. Koontz offers a powerful combination of in-depth knowledge of tax regulations, a firm grasp of the business world, and years of experience representing clients. To schedule a consultation, call the Sarasota office of Koontz & Associates, PL at 941-225-2615.