In general, if you owe money and it’s eventually written off in part or in whole, you are happy because you have put that dunning creditor behind you.  However, the next year when you file your tax return, you get a nasty surprise from the IRS.   It is a notice that they are adjusting your income; you forgot to claim it all.

What!  Well that dunning creditor sent a 1099-C at the end of the year.  Of course, not one of my clients actually receives this form before they file their tax returns nor expect to receive one.

 As far as Uncle Sam is concerned, the forgiven debt is taxed like income.  Why?

Basically, two sides of the same coin: one man’s deduction is the other man’s income.  For example, if a bank pays interest on your savings account, they get to deduct that money as an expense on their taxes – and you count it as income on yours. And if the bank lends money you don’t pay back, the bank deducts the bad debt as an expense – and you have to include it in your income.

That’s the rule and the logic behind it. But as with many rules, especially those relating to income taxes, there are many exceptions. Let’s look at a few:

·         Exception: insolvency:  According to IRS publication 4681, if you’re “insolvent,” meaning you owe more than you own, forgiven debt isn’t counted as income. Their words… “Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV (Fair Market Value) of all of your assets immediately before the cancellation.”  To qualify for this exclusion, you file Form 982.

·         Exception: bankruptcy:  Debt cancelled through a Chapter 7 or Chapter 13 bankruptcy typically isn’t taxable.

·         Exception: mortgage debt:  A foreclosure often includes cancelled mortgage debt – the amount of the mortgage not recouped when the home is taken back and resold.   Likewise, underwater homeowners often try to negotiate with their bank so that they can sell their homes for less than they owe in a short sale or have their mortgage balance reduced.  But the difference between what the homeowner owes and the lower sales price approved by the bank or the reduction in the mortgage balance is considered income for the homeowner and subject to tax by the Internal Revenue Service.  Since that results in forgiven debt, the result for many homeowners is losing their home or believing that they have gotten their finances straightened out, then months later getting a tax form in the mail informing them they owe taxes on potentially hundreds of thousands of dollars of income.  Fortunately, the Mortgage Forgiveness Debt Relief Act of 2007, came to the rescue.  Unfortunately, this law that spared people who owed more than their homes were worth from being saddled with extra taxes when their banks provide mortgage relief expired December 31, 2013. Congress hasn’t yet extended it.

Bottom line: seek assistance:  These are some common exceptions that could help you avoid taxes on forgiven debt, but they’re not the only ones.  Because of the detail (Publication 4681 is 26 pages long) and the amount of money involved, this is a situation that calls for expertise.

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Applying decades of experience, Steven Taylor will assess your financial situation and hear you out on your goals. The vast majority of the costs of the bankruptcy can be paid as part of your Chapter 13 plan, over time, making Chapter 13 an affordable solution as well as a life-changing one for many people with debt problems. To discuss your immediate concerns and long-term financial challenges, request a free telephone consultation with Steven Taylor today.  He can help you find the best solution and take decisive action to regain your financial foothold.

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Steven P. Taylor, P.C. | Indianapolis Chapter 13 Bankruptcy Lawyer

Contact the law firm of Steven P. Taylor, P.C. today at (317) 271-1111 for a consultation about whether you should file for Chapter 13 bankruptcy in Indiana or email us your questions.  Steven P. Taylor will assist you in determining whether a Chapter 13 bankruptcy is the best path for you, and will guide you through the bankruptcy process.