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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).

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