- Days left

Settle a Debt Last Year? Here's How You Can Avoid a Big Tax Bill

Lynette Khalfani-Cox photo logoDebt forgiveness – getting a company to write off a debt or let you pay less than you owed on a loan – might seem like a great thing at the time you do it.

What cash-strapped consumer knee-deep in credit card debt wouldn't enjoy the financial relief of settling their debts for perhaps as little as 50 cents on the dollar? And what struggling homeowner who wants to be rid of an unbearable mortgage wouldn't be glad to walk away from that loan – even if it takes a short sale or foreclosure to accomplish the trick?In all these instances, your creditors agree to let you off the hook financially. Even if it wasn't something you wanted -- say, in the case of a forced foreclosure or an auto repossession -- each of those actions results in the lender getting less money than you originally agreed to repay.

And that triggers the prospect of a big tax bill for you.

If you're one of the millions of Americans who got rid of a big debt last year – like a mortgage or credit card bills – through foreclosure, short sale or debt settlement, you've likely already received a 1099-C, a Cancellation of Debt.

By law, any company that writes off $600 or more worth of your debt has to send you – and the IRS – a 1099-C.

So now it's time to use that 1099-C and figure out whether you have to pay taxes on that canceled debt.

"There is no quick fix to financial problems like debt," says Richard Coppa, a Certified Financial Planner and managing director of Wealth Health LLC in Roseland, NJ. "Every short-term financial decision tends to have a long-term ramification and often times it's a tax ramification."

Under normal circumstances, debts that are forgiven result in taxable income to you.

But thanks to the Mortgage Debt Relief Act of 2007, if you got a 1099-C as a result of foreclosure, short sale or a mortgage modification, you've likely dodged a big tax bullet.

According to the IRS, under the Mortgage Debt Relief Act, married people filing a joint return can exclude up to $2 million of forgiven debt on your principal residence from income. (The limit is $1 million for singles or a married person filing a separate return). In other words, if you went through foreclosure, got your mortgage modified or did a short sale, you likely don't owe Uncle Sam a dime.

This special tax relief actually applies to anyone who has forgiven mortgage debt during the tax years 2007 through 2012. But starting in 2013, this tax break goes away.

For now, you can qualify for this tax relief, the IRS says, if you used the debt to buy, build or substantially improve your primary residence.

To claim this tax break, all you need to do is fill out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

Don't worry: you need not complete the entire two-page form. If you're just trying to pay zero taxes related to a foreclosure on your primary residence, you only have to fill out lines 1e and 2. For those who had modified mortgages with debt forgiveness, and remained in their homes, complete lines 1e, 2 and 10b.

Then simply attach Form 982 to your 1040 tax return.

How do you know what amounts to fill in? The amount of debt forgiven or canceled will be listed in Box 2 of that 1099-C you received. If all your debt qualifies because it was tied to your principal residence, the amount shown in Box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.

Pay close attention to the amounts listed on that 1099-C. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed. Again, the amount of debt forgiven will be shown in Box 2; the value listed for your home will be shown in Box 7.

While most homeowners with forgiven debt can likely escape taxes, some mortgage-related debt doesn't get this special treatment.

For example, debt forgiven on second homes, investment or rental property, and mortgage debt resulting from a home equity loan or line of credit that wasn't used to improve your home doesn't qualify for the Mortgage Forgiveness Debt Relief Act and is therefore subject to taxation.

Additionally, other types of forgiven debt don't meet IRS guidelines and will also require you to pay taxes.

These include forgiven debts for business property, consumer loans, credit card debt settled for less than you owed, as well as auto loan debt you no longer have as a result of a car repossession. You may be able to get relief from taxes on these debts, though, if you went through a bankruptcy.

As Coppa puts it: "Outside of that mortgage debt exclusion, if you have a 1099-C for a debt that you didn't wind up paying, you'll likely owe taxes on it."

Forgiven or canceled student loan debt is also generally taxable. But according to the IRS, you may be able to exclude forgiven college debt from your income if, as a condition of your loan(s), you agreed to perform certain work activities for a given time period, and you fulfilled those obligations.

If you have other questions about accounting for forgiven debt, get free tax help from IRS-trained volunteers through the VITA program, which is available nationwide.

Also, be sure to read IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. It's free when you call the IRS at 800-TAX-FORM (800-829-3676).

Increase your money and finance knowledge from home

Intro to Retirement

Get started early planning for your long term future.

View Course »

Goal Setting

Want to succeed? Then you need goals!

View Course »

TurboTax Articles

What is IRS Form 8824: Like-Kind Exchange

Ordinarily, when you sell something for more than what you paid to get it, you have a capital gain; when you sell it for less than what you paid, you have a capital loss. Both can affect your taxes. But if you immediately buy a similar property to replace the one you sold, the tax code calls that a "like-kind exchange," and it lets you delay some or all of the tax effects. The Internal Revenue Service (IRS) uses Form 8824 for like-kind exchanges.

What are ABLE Accounts? Tax Benefits Explained

Achieving a Better Life Experience (ABLE) accounts allow the families of disabled young people to set aside money for their care in a way that earns special tax benefits. ABLE accounts work much like the so-called 529 accounts that families can use to save money for education; in fact, an ABLE account is really a special kind of 529.

What is IRS Form 8829: Expenses for Business Use of Your Home

One of the many benefits of working at home is that you can deduct legitimate expenses from your taxes. The downside is that since home office tax deductions are so easily abused, the Internal Revenue Service (IRS) tends to scrutinize them more closely than other parts of your tax return. However, if you are able to substantiate your home office deductions, you shouldn't be afraid to claim them. IRS Form 8829 helps you determine what you can and cannot claim.

What is IRS Form 8859: Carryforward of D.C. First-Time Homebuyer Credit

Form 8859 is a tax form that will never be used by the majority of taxpayers. However, if you live in the District of Columbia (D.C.), it could be the key to saving thousands of dollars on your taxes. While many first-time home purchasers in D.C. are entitled to a federal tax credit, Form 8859 calculates the amount of carry-forward credit you can use in future years, not the amount of your initial tax credit.

What is IRS Form 8379: Injured Spouse Allocation

The Internal Revenue Service (IRS) has the power to seize income tax refunds when a taxpayer owes certain debts, such as unpaid taxes or overdue child support. Sometimes, a married couple's joint tax refund will be seized because of a debt for which only one spouse is responsible. When that happens, the other spouse is said to be "injured" and can file Form 8379 to get at least some of the refund.

Add a Comment

*0 / 3000 Character Maximum

2 Comments

Filter by:
Paul Young

LOAN OFFER APPLY NOW FOR MORE INFORMATIONS

Are you have any financial problem that you are finding difficult to solve.
We offer a variety of loans to individuals (personal loan) and cooperate bodies at an interest rate of 3% per annul.This is to help you meet your financial obligations, especially with the ongoing global financial crisis. We render out good loan of all kinds in a very fast and easy way, Personal Loan, Home Loan, Student Loan, Business Loan, Investor loan, Car Loan, Debt Consolidation. For further inquiries, please contact us via e-mail ( leonardfergusonfinance01@gmail.com ) Regards. hope to hear from you soonest. all respond to be forward to leonardfergusonfinance01@gmail.com for more information.


Leonard.

January 19 2015 at 10:37 PM Report abuse rate up rate down Reply
Johnny Elvis

A MUST READ:

Good day everyone, I am Mr Johnny Elvis by name, i am a citizen of new york USA, i have been looking forward for a genuine loan company for the past 2 months and all i got was group of scams who made me to trust them and at the end of the day, they duped me of $7000 without giving anything in return, all my hope was lost, i got confused and frustrated,i find it very difficult to feed my family, i never wanted to have anything to do with loan companies on net again, because i never trusted any loan company again since i was scammed, so i went to borrow some money from a friend, i told him all that happened and he said he can help me, that he knows a loan company that can help me, that he just got a loan from them, he directed me on how to apply for the loan, i did as he told me, i applied, though i never believed but i tried and to my greatest surprise my loan was granted to me within 24 hours, i could not believe, i am happy and rich again and i am thanking God that upon this scams all over the places a genuine company like this still exist, please i advise everyone out there who are in need of loan and can be reliable, trusted and capable of paying back at the due time of funds to contact (eladioloancompany@yahoo.com ) and be free from scams on the internet. they will never disappoint you.

July 26 2014 at 10:03 PM Report abuse rate up rate down Reply