The Tax Consequences of Debt Forgiveness

April 11, 2012

Guest post by North Carolina lawyer, John S. O’Connor

Especially in light of today’s distressed real estate market, the issue of debt forgiveness and associated tax liability has risen to the forefront. After a long battle to get a short sale or deed in lieu of foreclosure approved, many Americans are surprised when their tax bills shoot up. What they often don’t realize is that the IRS taxes forgiven debt as income. That’s right, although your lender may agree to forgive a considerable percentage of your mortgage debt, when they finally approve a short sale, they will also issue what is known as a 1099-C.

Form 1099-C

Creditors send a 1099-C form to you, the borrower, as well as the IRS when they’ve agreed to forgive or “write off” debt. The amount of debt listed on the 1099-C form is then imputed to you as income and increases your income tax liability in the year it is issued. Need an example?

Let’ s say the Smiths, like so many American homeowners, find themselves unable to afford their mortgage. They reach out to their lender and after jumping through numerous hoops, filling out countless forms and getting a buyer on the hook, the bank agrees to release its lien and approve their short sale. The Smiths owed $500,000 on their mortgage but the bank agreed to accept a sale price of $400,000 and forgive the remaining $100,000 balance. Great news right? Yes and no. Of course, it’s positive that the Smiths were able to avoid foreclosure and move on with their lives, but thanks to the 1099-C and the IRS, they have a surprise waiting when tax time comes around. Their taxable income just increased $100,000 (the amount forgiven by the bank). Even though the Smiths never pocketed this money, despite the fact that the loan proceeds were used entirely to finance the purchase of their home, the tax man will count the forgiven debt as income and send a bill.

The Mortgage Debt Relief Act

With underwater mortgages common throughout much of the nation, large tax events like this can cripple a family financially. For this reason, Congress passed the Mortgage Debt Relief Act of 2007, which allows homeowners to exclude up to two million dollars of forgiven debt from income if the debts were forgiven on the borrowers primary residence. Investment property and consumer debts, such as a credit card settlement, do not apply. For more information on the Mortgage Debt Relief Act, click here.

Debts Forgiven in Bankruptcy Are Not Taxable Events

In contrast to the tax treatment of debts forgiven through settlement, short sale or otherwise, debts forgiven in bankruptcy are not taxable events. Section 108 of the Internal Revenue Code explains that Title 11 (bankruptcy) cases are not subject to the traditional taxes on forgiven debt. Even after your bankruptcy discharge, you may still receive a Form 1099(c) from the IRS. If this happens, it is important that you fill out a Form 982 to tell the IRS that the debt was discharged in bankruptcy and, therefore, is not a taxable event.

Donna Bordeaux, CPA with Calculated Moves

Creativity and CPAs don’t generally go together.  Most people think of CPAs as nerdy accountants who can’t talk with people.  Well, it’s time to break that stereotype.  Lively, friendly and knowledgeable can be a part of your relationship with your CPA as demonstrated by Donna and Chad Bordeaux.  They have over 50 years of combined experience as entrepreneurial CPAs.  They’ve owned businesses and helped business owners exceed their wildest dreams.   They have been able to help businesses earn many times more profit than the average business in the same industry and are passionate about helping industries that help families build great memories.