Sometimes a person will fall into an unexpected situation and can’t pay their bills. Perhaps you know someone that lost your job and can’t make their mortgage payment, or your neighbor had a trusted adviser who turned out to be a ponzi schemer.
Maybe you have a relative crushed with high debt from overspending on first class airline tickets rather than collecting frequent flyer miles.
You might even know someone that has no income yet treats their credit card like their personal sugar daddy.
Whatever a person’s situation, many taxpayers don’t know what to do when he or she is trapped by high debt and unable to pay their tax bill.
Let’s take a look at a few answers to commonly asked questions on the debt puzzle and your federal taxes.
I am Insolvent?
A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. The forgiven debt may be excluded as income under the “insolvency” exclusion.
Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.
The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness.
My Debt is Forgiven?
The tax impact of debt forgiveness or cancellation depends on your facts and circumstances.
Generally, if you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes.
The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. There are several exceptions to the taxability of cancelled debt, such as insolvency or bankruptcy.
Additional information is found at the IRS.gov website and The Mortgage Forgiveness Debt Relief Act and Debt Cancellation.
Sell my Home for a Loss?
Losses from the sale of personal–use property, such as your home or car, are not deductible. It is not eligible for the capital gains loss of up to $3,000 annually.
For more information, see IRS Publication 523, Selling Your Home.
Lose my Home through Foreclosure?
Under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers generally can exclude income from the discharge of debt on their principal residence or mortgage restructuring.
This exception does not apply to second homes or vacation homes. In some cases, you may be able to file an amended tax return for previous tax years.
Additional information is found at the IRS website and The Mortgage Forgiveness Debt Relief Act and Debt Cancellation.
File for Bankruptcy Protection?
Debts discharged through bankruptcy are not considered taxable income.
If you are an individual debtor who files for bankruptcy under chapter 7 or 11 of the Bankruptcy Code, a separate “estate” is created consisting of property that belonged to you before the filing date. This bankruptcy estate is a new taxable entity, completely separate from you as an individual taxpayer.
Some tax debts are not discharged in a bankruptcy action. Here are a couple of examples for when debts are generally not discharged:
- Most student loans, recent federal, state, and local taxes.
- Child support and spousal maintenance (alimony).
- Government-imposed restitution, fines, and penalties.
- Court fees.
- Debts resulting from driving while intoxicated.
- Debts not dischargeable in a previous bankruptcy because of the debtor’s fraud.
Additional information is found in IRS Publication 908, Bankruptcy Tax Guide.