How the IRS Taxes Debt

In December Congress passed and the President signed the Mortgage Forgiveness Tax Relief Act of 2015. The act extends the tax exclusion for “canceled mortgage debt”. This affects taxpayers who were foreclosed upon or did short sales or renegotiated mortgages on their primary residence. The exclusion was first enacted into tax law in 2007 and has now been extended four times, this time through 2016. Affected taxpayers, like all taxpayers who had any sort of debt canceled, will receive a 1099-C form in the mail from their lenders and it’s up to them to report the debt and the reason for the tax exclusion on their tax returns. That’s done by attaching Form 982.

Since 2009 I’ve probably had 50 clients walk into my office with a 1099-C Form in hand (compared to maybe 10 during the previous 30 years of my tax preparing career). A few of these clients were able to use the exclusion for canceled debt on their primary home, but most had canceled debt on student loans or on vacation or rental property or had renegotiated credit card debt (from 2009 to 2012 US financial institutions “wrote off” about 10% of all outstanding credit card debt). Just about all of these clients seemed genuinely surprised to learn that canceled debt results in taxable income, which, of course, results in additional income tax. Politicians on TV constantly scream about how the banks mistreat the working man and the middle-class, but not one of them, none that I’ve ever heard, tell their constituents that the US Treasury (not to mention all of the state governments) are making money from people who can’t pay their bills. But it’s true unless taxpayers fall into one of 3 exception categories below:

Bankruptcy – The specific debt reported on 1099-C must’ve been canceled in a bankruptcy proceeding. Attach Form 982 to the tax return.

Insolvency – Taxpayers were insolvent on the day before the debt in question was canceled. There’s an “Insolvency Worksheet” in IRS Publication 4681, which is basically a balance sheet where a taxpayer can show that they have a “negative net worth”. Taxpayers should keep thorough documentation as it’s something the IRS will likely question.

Deductible Debt – This would apply if some of the mortgage debt canceled was from accrued interest (reported in Box 3 of Form 1099-C) and that interest could be claimed as an itemized deduction on the current tax return and wasn’t claimed in a previous year.

Note that when excluding interest on a primary residence due to a mortgage renegotiation or reduction, the basis of your investment in the residence must be reduced by the exclusion amount. This is accomplished by filling out Line 10 on Form 982. The basis of your house is an important factor in the event that you sell it or convert it to a rental property at some point in the future.

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