IRS - forviveness of debt tax question.?

Question

When a home seller receives a 1099 for forgiveness of debt in a short sale, is the income reported as miscellaneous income, or is the amount forgiven added to the tax basis, likely resulting in no taxable event? Or some other answer?

Answer 1

A recent New York Time article "After Foreclosure, a Big Tax Bill From the I.R.S." highlights a not well publicized fact of income tax law - discharge or forgiveness of debt is income to the taxpayer.

A simple fact pattern - You have a house with a mortgage of $100,000. You can't make your mortgage payments, and the house is foreclosed for $80,000 and total forgiveness of the mortgage. You now have no house and no debt obligation. However, you originally borrowed an additional $20,000 that the bank did not receive from the sale, and that you no longer have to pay back. Under Internal Revenue Code Sec. 61(a) (12), you have earned $20,000 dollars of income that you now owe tax on. The problem? You never got $20,000 in hand - instead, it is "phantom income" to you, upon which you need to pay tax in real cash ($4000 of tax at a 20% tax bracket).

Why are you deemed to have earned $20,000? Because your total net worth has increased as a result of not have to pay back the $20,000 (assets - liabilities = total net worth; if liabilities go down, total net worth goes up).

This fact pattern also applies where credit card or other debts are forgiven - ie: the creditor accepts as full payment less than the total amount borrowed.


IRC §61 - Gross Income Defined
61(a) GENERAL DEFINITION. --Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

61(a)(12) Income from discharge of indebtedness;


Where a debt is forgiven, is discharge of indebtedness income always the case? No. Where you have (1) filed bankruptcy under Chapter 11 (IRC Sec. 108 (a)(1)(A)), or (2) are insolvent at the time of the discharge (IRC Sec. 108(a) (1) (B)), then IRC Sec. 61(a)(12) does not apply.

The first exemption is easy - you either filed Chapter 11 or you haven't. The second is not so easy - you may feel you have no assets but not be insolvent under the Code.

To avoid a nasty surprise, make sure when paying off a debt for less than full value that you get in writing what they will be supplying to the IRS about the transaction.

Answer 2

Canceled debt reported to the IRS on a IRS form 1099C is carried to the other income line on your tax return. There are some means to make that amount non-taxable such as bankruptcy or insolvency otherwise it is taxable

Answer 3

It would be reported as miscellaneous income. If you can prove that you were insolvent at the time, you might be able to get out of paying tax on the cancellation of debt.

Answer 4

So the government forces regular people to become "insolvent" and therefore dependent on more government handouts when their home is upside down due to NO FAULT OF THEIR OWN??? Do you realize that the bubble burst in 2008 ... what else happened in 2008? Hmmmm....