Debt Relief

Today, with high credit card balances, mortgages exceeding the value of many homes, and other debt problems, individuals may be able to work out some arrangement with lenders. If the arrangement results in a reduction of what is owed, the borrower usually realizes income, called discharge of indebtedness income or cancellation of debt income. Such income is usually taxable, but there are three key exceptions:

• Insolvency
• Bankruptcy
• Special rule for homeowners

Insolvency

If an individual is insolvent at the time of debt forgiveness (debts exceed the fair market value assets of the individual), debt forgiveness is not includible in gross income. Insolvency is tricky to demonstrate; the assistance of a tax professional is advisable when relying on this to avoid tax on debt forgiveness.

Bankruptcy

If an individual files for personal bankruptcy, debt forgiveness under the terms of the bankruptcy plan is not includible in gross income.

Special Rule for Homeowners

Homeowners who experienced debt forgiveness in 2008 and received a Form 1099-C reporting this debt forgiveness as income may be confused about this. Is debt forgiveness taxable? Does this income have to be reported on the 2008 income tax return?

Under a special rule created by the Mortgage Forgiveness Debt Relief Act of 2007, the forgiven debt related to a principal residence may be tax free. This exclusion applies for debt relief in 2007 through 2012. Situations in which debt forgiveness can arise include:

• Foreclosure
• A short sale (selling the home back to the lender for less than the amount of the outstanding mortgage, with the lender forgiving the difference)
• A renegotiation of the terms of the mortgage for less than the outstanding balance

The excludable amount of debt forgiveness is capped at $2 million of debt forgiveness ($1 million for married persons filing separately). The mortgage loan must have been used to acquire, build, or substantially improve a principal residence, so the exclusion does not apply to debt forgiveness related to a vacation home, rental property, or business property. Similarly, there is no exclusion for debt forgiveness related to credit cards and car loans.

If you qualify for debt forgiveness related to your home, you must complete Form 982 and attach it to the return. Completing this form tells the IRS that the amount reported as income on Form 1099-C can be excluded under the home mortgage exception.

Other Tax Concerns

Reporting income from the discharge of indebtedness is not the only tax issue that can arise when debt is forgiven. An individual can have a taxable gain in some cases.

When a home is foreclosed upon, gain can result. A foreclosure is treated like a sale. Gain is the difference between the fair market value of the home foreclosed and the owner’s adjusted basis (usually the purchase price plus capital improvements).

If the owner has owned and used the home as his or her principal residence for at least 2 of the 5 years preceding the date of the foreclosure, then gain can be excluded up to $250,000 ($500,000 on a joint return). If this time test has not been satisfied, it may be possible to prorate the exclusion to tax on the gain for the period in which the test was met. A proration is allowed if a sale occurs because of “an unforeseen circumstance.” The IRS has yet to rule that a foreclosure is an unforeseen circumstance, but it arguably is so.

Some homeowners opt to sell their homes rather than go into foreclosure. Often, the homeowners sell for less than their original purchase price. Loss on the sale of a personal residence is not deductible in most cases.