Taxation of Canceled Debt: Foreclosure Backlash
So, you’re having trouble keeping your head above water with the mortgage payments on your home. You start to slip behind and find that your home is now being foreclosed.
You can now expect a Form 1099-C from your bank or lender stating that they are forgiving a portion of your debt that remains unpaid. Great news, right? Wrong. The debt that is being forgiven is now considered income to you by the IRS and you are now subject to taxation on that income.
You already have financial issues–that’s why you’re losing the home–so what are your options?
Find a Tax Attorney
First, try your best not to panic. This is not the end of the world. There are options available to you in order to avoid paying this extra tax. However, going to your accountant may not be the right choice as many accountants are unfamiliar with Cancellation of Debt income and the exclusions that apply. Additionally, many accountants prefer not to give out tax advice or come up with a strategy that may be used to avoid taxes. Accountants prefer to be “bean-counters” and work solely with the numbers and not with any strategy that may help the taxpayer. Therefore, get on the internet and find a trustworthy tax lawyer. Tax attorneys have the tools necessary to negotiate with the IRS and remove any additional tax liability that comes with a Form 1099-C. And, if it becomes necessary, a tax lawyer can litigate for you.
Qualified Principal Residence
The most common way to avoid the extra income stated in Form 1099-C is to use the Qualified Principal Residence Indebtedness (QPRI) exclusion. QPRI is defined as debt cancelled on the taxpayer’s “principal residence” as defined under IRC Sec. 121 (for the exclusion of gain on the sale of the taxpayer’s principal residence). QPRI is “acquisition indebtedness” (which means that the debt must have been incurred in acquiring, constructing, or substantially improving the taxpayer’s principal residence) up to $2 million ($1 million for married filing single).
For a taxpayer’s principal residence to be qualified for the exclusion the taxpayer must have owned and lived in the property as a principal residence for 2 out of the last 5 years. Therefore, if you, as the taxpayer, owned and lived in the home as a principal residence for 2 out of the last 5 years and the debt incurred was used in acquiring, constructing or substantially improving the taxpayer’s principal residence, then the Cancellation of Debt income may be excluded completely.
Your tax attorney will be able to review your unique situation and determine whether this exclusion applies to you and will work with the IRS, you and your accountant to exclude this debt.
The next most common way to avoid the extra income stated in Form 1099-C is to be insolvent. This is a tough pill to swallow for many taxpayers and no taxpayer ever wants to admit that they are insolvent. Being insolvent is not a bad thing in the world of taxes. This will allow the taxpayer to exclude the Cancellation of Debt income.
Under the insolvency exclusion, the taxpayer may exclude the cancellation of debt from income to the extent the taxpayer is “insolvent.” Debt discharge in excess of the amount by which the taxpayer is insolvent, is generally taxable income, unless another exclusion applies.
Insolvent means the amount by which all of the taxpayer’s liabilities exceed the fair market value of all of his or her assets. This also means that the cancelled debt may count as a liability for the purpose of determining the taxpayer’s insolvency. Insolvency must be determined immediately before the cancellation of debt occurs.
Therefore, finding a competent and trustworthy tax attorney can be the difference between paying thousands of dollars in extra tax or paying very little to nothing in extra tax.
If you are already an HLA client, then you have access to tax counsel right along with your foreclosure attorney. Simply contact the office and ask for a free consulation.
If you are not already a client, please fill out the form below and one of HLA’s competent tax attorneys will contact you to assist in any tax matter that you may have.
~ Craig W. Young, Esq.