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Tax Consequences for Forgiven Debt
As more families refinance their mortgages, are forced into foreclosure or find other ways to cancel their mounting debt, the last thing that may be on their minds is...
June 13, 2009 /Stock Market PR News/ -- Tax Consequences for Forgiven Debt
Article provided by Clark Law Offices
Visit us at www.clarklawaz.com
As more families refinance their mortgages, are forced into foreclosure or find other ways to cancel their mounting debt, the last thing that may be on their minds is the potential tax consequences of their actions. But whenever a lender forgives a debt, the cancelled debt becomes part of your taxable income -- which could make for a very unpleasant surprise at tax time.
Generally cancelled debt refers to any money you have borrowed from a lender that you do not have to repay because the lender "forgave" the amount owed. For example, if you owe $500,000 on your home and the house is sold in a short-sell for $400,000 and the bank forgives the remaining $100,000 owed on the loan, that $100,000 is cancelled debt.
Lenders are required to file a 1099-C Cancellation of Debt form whenever they forgive a debt greater than $600. This form is filed with the IRS and a copy is sent to the borrower. The form will show the amount of cancelled debt as well as any interest forgiven on the debt. In some instances, interest from cancelled debt may not have to be included as taxable income. If you choose to repay a portion of a cancelled debt, you may be able to file a claim for a refund of any taxes you paid on the debt.
Not All Cancelled Debts are the Same
There are some limited, but very useful, exclusions and exceptions to the cancelled debt/income rule. The following types of cancelled debt are not taxable:
* Debt discharged in bankruptcy: those who had debt discharged in a Chapter 11 bankruptcy do not have to claim the cancelled debt as taxable income.
* Insolvency: taxpayers who meet the IRS definition of insolvency do not have to pay income taxes on forgiven debts. Insolvency occurs when the total value of your property (assets, bank accounts, income) is less than the total amount of your liabilities (debt owed, financial obligations).
* Student loans: if the student loan contained a provision allowing for some or the entire loan to be cancelled in exchange for the student accepting certain types of employment, then the amount of cancelled debt may not be taxable.
* Qualified farm debt: certain types of forgiven farm debt are excludable.
* Non-recourse loans: loans that only permit lenders to repossess the property the loan was used to purchase, rather than going after the borrower's personal assets, are not included as taxable income if they are forgiven.
Mortgage Forgiveness Debt Relief Act
Debt cancelled in connection with a home mortgage refinancing or home foreclosure also may be excluded from taxable income. In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act to help protect homeowners already in financial straits from harsh tax consequences. The Act currently is valid through 2012.
The federal law applies to cancelled debt from foreclosures and mortgage refinancing in connection with the homeowners' primary residence. In the case of refinancing, only the amount up to the old mortgage principal balance immediately before the refinance is eligible for the exclusion. The maximum amount of debt that may be exempt is $2 million. For married couples filing separate tax returns, the maximum is reduced to $1 million.
The Mortgage Forgiveness Debt Relief Act does not apply to second homes, business properties or rental properties. It also does not apply to other types of cancelled debt, like credit cards or car loans.
Conclusion
Just because a cancelled debt is excluded from your taxable income does not mean you do not have to report the cancelled debt to the IRS. The excluded income also could have other tax consequences. It is important to consult an experienced tax advisor for information on the potential impact forgiven debt may have for your specific situation.
Article provided by Clark Law Offices
Visit us at www.clarklawaz.com
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