When you owe money to a private party and that party cancels the debt, this is debt forgiveness. However, if you owe this debt to a major lender, you will be responsible for that debt in a different manner. It may become reportable income and subject to taxation when you file your income tax return.
The Mortgage Debt Relief Act of 2007 is in effect until 2012 to ease the burden of taxpayers in default, foreclosure or repossession. Debt forgiveness (under this act) becomes a Cancellation of Debt. The Internal Revenue Service Publication 4681 explains the provisions of this Act.
Cancellation of Debt
Cancellation of Debt is the term for an action that allows you the benefit of debt forgiveness from a commercial lender. The amount the lender forgives may become taxable income, depending on specific individual circumstances.
When you stop making your loan payments, you are in default of terms of the loan note. If the sale of real estate or vehicle is not enough to cover the remaining principal on the loan, the lender loses money. This is a short sale.
Debt or Income
When a lender faces a loss from an auction or a short sale, someone needs to pay this shortage. The borrower is the responsible party. There comes a point when an impossible debt becomes unrealized taxable income.
A shortage of $600 or more obligates a lender to report the amount of cancellation to the IRS. The borrower will receive Form 1099-C, Cancellation of Debt. Form 1099-C reports debt forgiveness as taxable income.
Two Simple FAQs
Does debt forgiveness always become taxable income?
Certain situations render debt forgiveness exempt from taxation. The most obvious applies to a loan for your qualified principal residence. The Mortgage Debt Relief Act of 2007 made this possible.
Bankruptcy is another instance that exempts a cancellation of debt from becoming taxable income. If you are insolvent beyond a shadow of doubt, most (or all) of the forgiven debt becomes non-taxable income.
Does debt forgiveness apply to all loans?
The MDR Act of 2007 applies only to loans that relate to buying, building or improving your principal residence. The cancellation of this debt must identify the home as collateral for the loan.
Student loans that originate from a government agency usually remain in effect unless you sign a clause to work in a public service position or underprivileged areas. Debt that arises from using credit cards will qualify for forgiveness if they are a discharge in Chapter 11 bankruptcy. Debt forgiveness could occur if you are insolvent--and can prove your debts outweigh assets.
Debt Forgiveness Exclusion
The IRS provides Form 982, which taxpayers can use to report Cancellation of Debt. This is a request for the exclusion of the debt forgiveness amount from taxable income. Follow the instructions that apply to your situation.
The amount of debt forgiven will appear in Box 2 of Form 1099-C. You will enter this amount on the correct line of Form 982. For those receiving a Cancellation of Debt resulting from a foreclosure auction or short sale, only lines 1e and 2 are necessary.
Go It Alone
It is best to make requests or offers to your lender in person. Having an attorney or a tax professional, or both, in the background is also advisalbe. There are those who would run to a debt settlement agency and pay thousands of dollars in fees. The reality is that lenders are usually willing to work with you directly.
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