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Is Cancellation Of Debt Haunting You With Phantom Income?

If you thought your money problems were solved when you settled your credit card debt, you might be in for a ghostly surprise.  For many with debt struggles, once the debt collector stops haunting you, the taxman comes trick-or-treating at your door. You may be done negotiating with your credit card company to settle the amount owed and to arrange a repayment plan, but you may still feel broke and doubt your ability to pay your bills.

Nevertheless, that debt reduction may be phantom taxable income to you, meaning you have no cash in hand but may still owe taxes on it.  The fact is that many are simply not aware of the tax implications of debt forgiveness or of settling to pay a lesser amount than they owe in credit card and other debt.  Depending on the amount of the debt cancelled, it could have a significant impact on your income tax bracket, deductions and other factors such as the alternative minimum tax.

CANCELLATION OF DEBT DEFINED

If you borrow money and the lender later cancels, settles or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances.  When you initially borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender.  If that obligation is later forgiven, meaning that you no longer have an obligation to repay the lender, the cancelled amount is reportable as income.  The lender is normally required to report amounts of canceled debt in excess of $600 to you and the IRS on Form 1099-C, Cancellation of Debt.

Here’s a very common example.  You have accumulated $10,000 in consumer credit card debt despite diligently paying the minimum balance for several years.  Your credit card company or third-party agent such as a consumer credit counselor or debt settlement specialist contacts you to settle for pennies on the dollar – a very common practice in the consumer credit industry.  After some tough negotiation on your part, you manage to settle the debt for $3,000.  You breathe a sigh of relief and continue in your quest to become debt free.  Then, in January of the following year you receive a wake-up call in the mail: Form 1099-C in the phantom (but very real) amount of $7,000.  This is forgiven debt that is reportable taxable income (whether or not you actually receive a 1099-C).  Bear in mind, however, that if the creditor continues to attempt to collect the debt, then it has not been cancelled and you do not have income.

There is, however, some relief from taxability if your canceled debts meet the requirements for any of the following exceptions or exclusions cited by the IRS.

EXCEPTIONS AND EXCLUSIONS

EXCEPTIONS to Inclusion in Gross Income:

  1. Amounts specifically excluded from income by law such as gifts, bequests, devises or inheritances
  2. Cancellation of certain qualified student loans
  3. Canceled debt, that if it were paid by a cash basis taxpayer, would be deductible
  4. A qualified purchase price reduction given by a seller
  5. Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program

EXCLUSIONS from Gross Income:

  1. Debt canceled in a Title 11 bankruptcy case
  2. Debt canceled during insolvency
  3. Cancellation of qualified farm indebtedness
  4. Cancellation of qualified real property business indebtedness
  5. Cancellation of qualified principal residence indebtedness up to $2 million ($1 million married filing separately) that occurred between 2007 and 2014 (yet to be renewed for 2015 as a tax extender) under the Mortgage Forgiveness Debt Relief Act

Generally, if your canceled debt is excluded from income under one of the exclusions listed above, you must reduce certain tax attributes (i.e. certain credits, losses, basis of assets, etc.), within limits, by the amount excluded by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the amount qualifying for exclusion and any corresponding reduction of those tax attributes.

With regard to insolvency, the exclusion applies up to the amount by which your liabilities exceed your assets.  For example, if $60,000 of debt is forgiven and your liabilities exceed your assets by $25,000, then only the $25,000 is excluded from income; the remaining $35,000 is taxed.

For cancellation of qualified principal residence indebtedness that you exclude from income, you must only reduce the basis in your principal residence.  Also, the portion of a home equity line of credit that is not used to make home improvements (such as to pay off credit cards), will not qualify for the $2 million exclusion.  On the other hand, if you use a credit card to pay for home improvements on your primary residence and can prove it, you may be able to claim such debt for exemption from mortgage-related debt forgiveness income.

Note:  If your debt is secured by property that is repossessed by the lender in full or partial satisfaction of your debt, you are treated as having sold that property and may have a taxable gain or loss.  The gain or loss on such a deemed sale of your property is a separate issue from whether any cancellation of debt income exists.  We will discuss the tax ramifications of this scenario in a future article.

If you have any further questions regarding debt, please contact Victor C. Belgiorno at 516-861-3704 or  or Bob Jahelka at 516-861-3707 or .

 

 

 
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