"FORGIVENESS OF DEBT" TAX EXCEPTIONS: BANKRUPTCY, INSOLVENCY, PRINCIPAL RESIDENCE

Sean Sullivan Hanley

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Chapter 7 Bankruptcy Attorney

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Posted about 3 years ago. 1 helpful vote

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The IRS taxes individuals on "relieved" or "forgiven" debts. Forgiven debts are debts in which the creditor agrees to take nothing or less than the full balance owed, or debts that the creditor has written off ("charged off"), declared as uncollectible, and reported as a tax loss to the IRS. The IRS treats "debt relief" or "debt forgiveness" as ordinary income, which is typically tacked onto the debtor's gross income and taxed as such. Thus, while a debtor may be "relieved" from paying a debt back to a creditor, the debtor must pay ordinary income taxes for the amount of debt that was relieved, absent a tax exception.

Lending institutions, such as a bank, credit union, savings and loan, or other financial institution that "relieve" or "forgive" a debtor from paying a debt for $600 or more must send the individual whose debt was relieved/forgiven IRS Form 1099(C) at the end of the tax year. When the taxpayer files their tax return, they must report the debt that was written off as income and pay income taxes on it.

There are three exceptions to the rule that consumers have to pay income taxes on forgiven debts. Even if the financial institution issues a Form 1099(C), an individual consumer does not need to report the income on their tax return if:

  1. The debt is discharged in Bankruptcy;

  2. The forgiveness is intended as a gift (uncommon); or

  3. The taxpayer was "insolvent" before the creditor agreed to waive the debt.

The IRS does not define "insolvent;" however, the general rule is that the debtor's liabilities exceeded their assets at the date the creditor agreed to waive the debt. Note, the amount of "forgiven" debt should be included in the analysis when determining whether a debtor is "insolvent."

If it is determined that the debtor was "insolvent" when the debt was "relieved/forgiven," then the debtor must file IRS Form 982. See Foreclosure - Debt Relief Income for a more in-depth discussion on Debt Relief Income and IRS Form 982.

Another common debt relief scenario occurs in the real estate arena when a homeowner's "underwater property" {fair market value of the property is less than the 'recourse' loan(s) amount(s)} is foreclosed on. The homeowner incurs "debt relief" income in the amount that represents the difference between the fair market value and the recourse loan(s) amount(s).

There is also a homeowner's "principal residence" tax exception in a foreclosure of real property context, whereby a homeowner-debtor may not have to pay income tax on debt that is relieved in association with their "primary residence." Under the Mortgage Forgiveness Debt Relief Act of 2007, if a mortgage debt is entirely forgiven during the tax years of 2007 to 2012, those homeowner-taxpayers may be able to exclude up to $2 million of debt forgiveness on their "principal residence". The limit is $1 million for a married person filing a separate return. It is important to note that this tax exception only applies to debt forgiveness on a debtor's principal residence, which can be a matter of debate and argument.

The IRS considers a taxpayers "Principal residence" as the home that the debtor lives in most the time, which can be a house, houseboat, mobile home, cooperative apartment, or condominium. One must have lived in their primary residence for at least 2 years during the 5-year period ending on the date of sale of the property. If a person has two homes and they live in both of them, their principal residence is ordinarily the one they live in most of the time.

See Foreclosure Guide for an in-depth discussion on the various issues associated with California Residential Real Property Foreclosure, including "primary residence" tax exception to forgiveness of debt on recourse loan deficiency.

It is important to note that in addition to the benefits received by debtors that file for Bankruptcy and hence qualify for the favorable tax exception that allows debtors to not report debt relief income (#1 above - filing for Bankruptcy), filing for Bankruptcy also alleviates many debt concerns of defaulting homeowners with under water real property that is secured by recourse loan(s) as debtors are able to discharge the unsecured portion of the debt(s) owed, thereby escaping any and all personal liability for the default. See Foreclosure Guide and Bankruptcy and Foreclosure for more information on the impacts of Bankruptcy and Foreclosure.

Additional Resources

Hanley Law

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