How Forgiven Debt Begets Tax Issues

Originally published on Passive Activities and Other Oxymorons on May 23rd, 2011.
____________________________________________________________________________
I've been searching for guest bloggers, but this one found me. Angela Sanders is affiliated with the Oak View Law Group and has guested on several blogs.

When you settle your debt in less than you owe, a sense of complacency may overpower you. But let me caution you that your forgiven debt is soon to get exposure to the IRS. The amount you are forgiven by your lender is deemed to be your income and so the IRS will levy taxes on it. However, if you consolidate debt, it will restructure your lending term whereby you will pay your debt in an elongated time frame. In that case, no tax may be imposed on you as you are paying principal balance to your lenders. But, apart from some specific cases, a borrower must pay the taxes for his ‘charged off’ debt. It may be your forgiven debt after mortgage foreclosure or forgiven credit card debt.


Even when your home is foreclosed, you may not be exempt from the liabilities of your unpaid mortgage balance. After the foreclosure process is done, the lender will take possession of your house and then he will try to recoup his losses by selling it through an auction. The lender will sell your house for that much money what you owed to your mortgage lender. If the house gets proper valuation, then the bank will accommodate the selling proceeds with the unpaid mortgage balance. Then the borrower will no longer be tied to any kind of mortgage related debt.

However, if the house does not sell well, the bank will try to sell it through a real estate agent. In that scenario, the bank will usually try to sell it as soon as possible. Because, this time the bank will be responsible for the upkeep of the house and even during that time it has to reckon for the taxes. So, chances are  that the property may be sold for less than the mortgage balance. The lender has to face mortgage deficiency for not getting the proper value against his mortgage loan. Now, either he has to sue against the borrower or discharge his debt completely. If the lender discharges the debt, the borrower will receive a Form 1099 which he has to fill up along with his yearly tax return. Forgiven debt accrues significant tax consequences for the debtor which he has to show in his tax return.

Now, in some cases a forgiven debt may also get tax forgiveness.

1. If the foreclosed house is not the primary residence of the former home owner.

2. If it is not a guest house or commercial property of the debtor.

3. If the mortgage balance is less than $ 1 million of a bachelor.

4. If the mortgage balance is less than $ 2 million for married people.

5. A borrower can obtain tax forgiveness by filling a Form 982 along with their tax return.

What is very significant is that debt forgiveness can also leverage a lender by offering him some tax benefit. He can compensate some of his loss by having some tax deduction.

PAOO Comment - I have done a few posts about people getting caught by surprise by debt discharge income.  Here is an example.  Probably the most common exception that will apply is that debt discharge income is not taxable to the extent of the taxpayers insolvency.  As the case I just highlighted illustrates though you have to be able to document your insolvency.