Reprint from Had Enough (soon to be published)
with permission of Ken Gross Copyright 2009
Okay – let’s talk about everyone’s least favorite subject and most hated agency. Take a wild stab. The subject – taxes. The agency – the Internal Revenue Service – IRS. For some, anxiety ensues by the mere mention of the words. For others, anger and for many, passive indifference. Regardless of the emotions, we all know the old adage that there is no escaping death and taxes. That is an absolute truth when it comes to “death.” I can tell you that Had Enough does not have a chapter or theory on how to avoid that eventuality (though I do have some ideas on how to prolong the inevitable). When it comes to taxes, it is true that you cannot avoid the existence of taxes and your obligations to pay, but there are circumstances where you can sometimes successfully discharge or reduce your existing tax liability. Additionally, there are steps and procedures that you can follow in order to obtain time to pay past due tax bills so that you do not have to live in fear of having your bank account or wages levied without notice.
One of the most troubling tax issues that people in financial crisis face is the circumstances where the government taxes them on “forgiveness of debt.” This situation arises with short sales, deeds in lieu of foreclosure, foreclosure and debt resolution. The problem is that under several situations, where the creditor receives less that was originally loaned, the difference can give rise to income tax consequences to the individual – and this occurs at a time where they money is certainly not there to pay the tax. There are exceptions and some of them take some planning, so you need to pay attention. This is an area that I find the media and commentators do not give enough attention – so this is my attempt to provide you the information that is needed to make the proper decisions. After all, how much good does it do you if we are successful at eliminating $75,000 of debt through Debt Resolution, but at the year end you receive 1099s from the creditors and your accountant tells you that you must pay tax on the $75,000. The answer – well it’s still good, but not that good and now you have a new problem. Taxes due and no money!
When is Forgiveness of Debt Income?
The best way to understand this rather annoying issue is to set out the general rule as stated by the IRS in its Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments (you can find this at www.irs.gov/pub/irs-pdf/p4681.pdf). Here it is:
“Generally, if you owe a debt to someone else and they cancel or forgive that debt, you are treated for income taxes as having income and my have to pay tax on this income.”
You are probably thinking this is ridiculous. How can I pay tax when I’m not getting any money to pay the taxes? I share this sentiment and to some extent our friends and foes in the IRS and Congress recognize that this can be a significant problem.
Let’s examine briefly why it is considered income. The rationale goes like this. When you receive the credit – either through the use of credit cards or borrowing from the bank for a mortgage loan – that money you receive is not income because it is a loan. Your obligation is to repay the loan so it is not income. If, however, when the money was provided to it was not a loan, but rather you won it at the racetrack or in a lottery, then that money would have been income. This is where the tax aspect comes in to play. When the debt is canceled, it is the same as if you won the money at the racetrack or lottery, except, in the cancellation situation, the victory comes later when the money is not there. The notion that money your receive is taxable when you receive it with no obligation to repay (other than a gift) is not that difficult to comprehend. Cancellation of a debt yields the same result, except for the timing because the cancellation comes, for all practical matters, at a time where you don’t have the money that you received. Gifts, on the otherhand, in contrast to gambling or winning a contrast are not considered income. The distinction rests with the person making the gift – if that person is detached and disinterested and making the gift with no expectation in return, then it is not income. The same would be true if that same person made a loan and than elected to forgive it to you. For example, if your parents loaned you money to buy a home and then, from the kindness of their heart elected to cancel the debt, that event could qualify as a gift and there would be no income tax consequence. When a bank, however, cancels the remaining credit card balance on a settlement or forgives the balance of debt owed on a mortgage, that transaction is not related to the kindness of the bank’s heart and it does not meet the standards needed to be considered a gift.
In the housing sector with foreclosures, as well as repossessions for property such as vehicles, there are two events that actually occur from a tax standpoint. The foreclosure or repossession is treated as a sale which can require you to realize gain or loss on the transaction. Typically, there is little in the way of gain realized in a foreclosure or repossession, so we will not dwell on this point. The second event, however, is significant. According to IRS if the outstanding loan balance was more that the FMV of the property and the lender cancels all or part of the remaining loan balance, you also may realize ordinary income from this cancellation of debt. You must report this income on your return unless certain exceptions or exclusions apply.
The dreaded IRS Form that reports these events is the 1099-C. A lender is required to file Form 1099-C and send you a copy if the canceled debt is $600 or more and the lender is a financial institution, credit union, federal government agency or any organization that has a significant trade or business of lending money. Looking at the bright side, if you’ve defaulted on your second mortgage to Uncle Leo, at least he is not required to file the 1099-C. (Of course, this does not mean that you can ignore the income tax consequences, if they exist; only that IRS will not learn of the event from Uncle Leo).
So now the stage is set. The bad news is that the canceled debt, whether it is from a credit card, short sale or foreclosure, will generate a 1099-C from the IRS and you will have to report the income on your taxes unless there is an exception. The good news is that there are three major exceptions that help to eliminate the requirement that you report the canceled debt as income. The exceptions do not work in every situation so you need to be sure to analyze this issue in the planning and operational plan of you Financial Crisis Management strategy.
Exception #1 – Bankruptcy Filing
The first exception is the biggest, broadest and easiest. If you file for bankruptcy protection Debt Canceled is not included in income. The only conditions are that if you file a Chapter 7, the case must be completed to discharge (the normal course) or if a Chapter 13 or Chapter 11, the plan must be approved. The existence of this exception emphasizes the benefits of the bankruptcy laws. To me, it serves as a reminder, that when it comes to achieving the goal of preserving future income rather than allowing it to pay debts of the past that the bankruptcy laws are an excellent tool and that people need to shy away from the notion that bankruptcy must be avoided at all costs. The point here is that if the consequences of Debt Cancellation give rise to tax obligations that could otherwise be avoided by a bankruptcy filing, then that alternative must be looked at. The situation will depend on the circumstances but it is safe to say, that if our goal is to shed debt and preserve future income, we certainly do not want any unneeded tax obligations to good old Uncle Sam!
Exception #2 – Qualified Principal Residence Indebtedness
The Emergency Economic Stabilization Act of 2008 extended the Mortgage Debt Relief Act of 2007 and provides for an exclusion of income from the discharge of debt on your principal residence if the debt is forgiven after 2006 and before the end of 2012.
The debt that can be excluded is called “Qualified Principal Residence Indebtedness.” It includes “any debt incurred in acquiring, constructing, or substantially improving your principal residence and which is secured by your principal residence.” (Page 7, IRS Publication 4681). Refinanced debt is also included up to the amount of the debt refinanced or to the extent that the additional money obtained on the refinance was for improvements to the residence. If, however, you refinanced to pull money out to pay off credit cards and other non-housing items that money is not excluded under this exception. This is a very important exception – if you refinanced the home and pulled money out to pay off credit card bills – that portion of the debt is not Qualified Principal Residence Indebtedness and the exclusion on Cancelled Debt does not apply to the extent of that debt. The IRS calls this the “Ordering Rule.” What it really means, is the “order” is that when there is a refinance and some of the money was used to pay down other debt, that amount is not eligible for the exclusion under this exception.
There are two other limitations that come into play with this exception. The maximum exclusion is $1 million per individual and $2 million if married filing a joint return. Also, this exclusion only applies to your Principal residence, which is defined as “the home where you ordinarily live most of the time” (IRS Publication 4681, Page 7-8). You are also only permitted to have one principal residence at any one time. So to recap – the Qualified Principal Residence exclusion covers:
QUALIFIED PRINCIPAL RESIDENCE EXCLUSION FROM CANCELED DEBT INCOME
|Eligible Years||Debt Discharged After 2006 and before 2013|
|Maximum Exclusion||$1 Million Per Individual
$2 Million for Married filing joint
|Excluded Debt||Debt incurred in acquiring, constructing, or substantially improving your principal residence and which is secured by your principal residence|
|Not Excluded||Amounts refinanced to pay down credit cards and other bills|
So what if you are not filing bankruptcy and you are going to be receiving a 1099-C from a lender arising from cancelled debt on a short sale or a credit card settlement. Must you pay income taxes on this so-called income even though you have no money? Well, all is not yet lost. There is another exception and it is called the Insolvency Exclusion.
Exception #3 – Insolvency Exclusion
This is a big exclusion and often, but not always, covers the problem. You do not include a canceled debt as income to the extent you were insolvent immediately before the cancellation. The calculation is easy. You add all the fair market value of all of your assets – including retirement accounts (IRAs and 401(k) accounts, etc) and all property you own. Now add all liabilities (debts), including credit cards, mortgages, medical bills, student loans, past due interest on loans, judgments, loans on insurance policies, margin debt, etc. To the extent your liabilities exceed your assets, you are “Insolvent.” If the total amount you are insolvent is $100,000 and the credit card companies cancel $60,000 of your credit card debts, you will not have to report the $60,000 as income because you are permitted to exclude up to $100,000. If however, the total amount the banks and credit card companies canceled was $110,000, then you are maxed out at $100,000 and the additional $10,000 must be reported as income.
The end result of this rule is that to the extent that after the cancellation of the debt, your assets exceed your liabilities, you will have to pick put the income up to the income subject to the maximum amount of the amount of the cancelled debt. Take the above example, before the debt is cancelled, you were insolvent by $100,000. Because the debt that was cancelled is $110,000, you are now is positive, or solvent, by $10,000. You must therefore pick up $10,000 of income and can only exclude $100,000.
An interesting issue that arises in the Insolvency exception analysis and in the Bankruptcy Exclusion analysis is whether the taxpayer can include in the liabilities the amount of a debt that the taxpayer has guaranteed. Typically, this situation arises when the taxpayer’s business has loans outstanding which he has given his personal guaranty to the bank. Another scenario, is where a person guarantees an auto or other loan on behalf of a family member or a friend (this by the way, is never a good idea!). The law distinguishes a guaranteed debt as a contingent liability. The critical factor here, from the standpoint of the tax consequences on the exclusion, is whether it was more likely than not that they would be required to pay the liability when dealing with a contingent liability. In Tax Court cases addressing this rule, the Court has ruled against the taxpayer in circumstances where the taxpayer failed to prove it was more likely they would have been required to prove the liability. This is another important planning point that is often ignored but can be very significant.
You Can Use More than One Exclusion and the Bottom Line
Suppose you did refinance your home and pull money out to pay off credit card debt? In this case, you can still use the Qualified Principal Residence Exclusion on the non-refinance portion and then apply the remaining portion against the Insolvency Exclusion to see if you can exclude all or a portion of the remainder.
The bottom line is simply that that the tax issue is a material issue that must be evaluated and planned for in the context of eliminating debt and preserving future income. In many situations, the recognition of Cancelled Debt as income is a non-issue. In situations where you’re not filing bankruptcy, the issues require you to run through a few critical questions to evaluate the issue:
QUESTIONS TO SCOPE OUT THE ISSUE –CANCELLATION OF DEBT AS INCOME ANALAYSIS
|1||Is a Short Sale or Deed in Lieu of Foreclosure at Issue||Need to watch for Cancellation of Debt Income and if you refinanced the home and pulled money out to pay credit card bills, etc|
|2||Has the Mortgage Lender Reduced the Principal or Cancelled the Remaining Debt||(Same as Above)|
|3||If Question 1 or 2, above apply, but you did not refinance||Then if this is your Primary Residence and the cancellation occurs after 2006 and before 2013 you’re protected under the Qualified Principal Residence Exclusion up to $2 Million for Married Filing Joint and $1 Million for an Individual|
|4||Have you received Cancelled Debt from a Credit Card lender or a lender other than your Mortgage Lender on Your Primary Residence?||Then you will be protected if you file for Bankruptcy Protection* otherwise you need to analyze the Insolvency Exclusion|
|5||You Have Received Cancelled Debt and you’re not filing Bankruptcy and it does not qualify for the Qualified Principal Residence Exclusion – so you need to analyze the Insolvency Exclusion||Calculate you’re Total Assets and Subtract your Total Liabilities immediately prior to the cancellation— if negative, you are Insolvent.Income is Excluded Up to the Amount You are Insolvent|
*You still must be careful of Contingent Liability issues as to Exclusion from Income Tax
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