Beware: Cancelled Debt from Loans & Foreclosures Can Impact Taxes

Taxpayer Beware: Cancelled Debts from Student Loans, Foreclosure and Other Events Can Have a Serious Tax Impact

Unfortunately, taxes and the tax treatment of an array of an array of income and other events are anything but simple and straightforward. However, the IRS has successfully argued many of its positions in tax and other federal courts. Therefore, while the tax handling may not be immediately apparent if you haven’t spent a significant amount of time reviewing the U.S. Tax Code, IRS regulations, and court decisions the IRS’ determinations are the law of the land and taxpayers are obligated to comply. 

One of the areas that most frequently causes issues for taxpayers in today’s world of massive student loan bills is when a student debt is forgiven due to the passage of time or for other reasons. While student debt is not typically dischargeable in bankruptcy, there are situations where it can be cancelled. Likewise, the foreclosure and forgiveness of the underlying mortgage debt can also have a significant tax impact.

Robert Hoffman of the Hoffman Law Offices can assist taxpayers with an array of financial and tax concerns. Mr. Hoffman can provide trusted guidance if you have had significant debts discharged or when facing certain business events.

Cancelled and Forgiven Debts Must be Reported on a 1099-C

Decades ago, cancelled debt was reported rather unevenly. Today, the IRS has significantly tightened up the reporting regime surrounding debt that is cancelled or otherwise forgiven. Taxpayers today are expected and required to report all cancelled debt. Taxpayers are “encouraged” to take this action because the party cancelling the debt is required to issue a 1099-C. The 1099-C reports the amount of debt cancelled and is part of the IRS’ form matching process. Therefore, taxpayers who were issued a 1099-C but fail to include it on their tax return raise red flags in the IRS’ system.

IRS tax law

Cancelled debt can arise in a number of ways, but the two most common ways it arises in today’s world is through student loan debt and the foreclosure of a home. While student loan debt is not dischargeable in bankruptcy, certain loan repayment programs provide for cancellation of debt after a certain period of repayment. For instance, the Income-based Repayment Plan has this feature. Another common means of incurring cancelled debt is through a home foreclosure. While many people think they can just walk away from the home free and clear of the debt, the actual handling is much more complex.

Forgiven Debts Are Typically Treated as Taxable Income

In most cases, this debt is treated as income and gives rise to a corresponding tax obligation. §61(a) of the Internal Revenue Code states that the definition of “income” includes the income that is realized through the discharge of indebtedness that is $600 or greater. Needless to say, for an individual with six-figure student loan debt or similar amount of cancelled mortgage debt, the tax impact can be financially catastrophic.

However, there are certain exceptions to this handling. In the context of student loans §108(f)(1) of the Internal Revenue Code states that student loan forgiveness is not treated as income in circumstances where the forgiveness was conditioned upon the fact that the “individual worked for a certain period of time in certain professions for any of a broad class of employers.”

While the above can provide relief to certain student borrowers, other aspects of the tax code can provide additional relief to those who have experienced a home foreclosure and cancellation of the underlying mortgage debt. §108 of the Internal Revenue Code states that any debts discharged through the bankruptcy process are not counted as income. Additionally, the insolvency of the taxpayer can also result in the cancelled debt not qualifying as income. Furthermore, a portion of the mortgage debt that would not have otherwise been deductible will also not count as income.

IRS exchange of information

In short, the rules regarding the tax impacts of forgiven debt are not particularly straight-forward or intuitive. Furthermore, the above merely scratches the surface on the level of nuance and determinations that go into assessing the tax impact of a certain cancelled debt. If you are facing a situation where you suspect that you will soon face a significant amount of cancelled debt, it is wise to consult with a tax attorney who can assess the situation and provide you time to prepare for a potential major tax liability.

Work with a California Tax Attorney for Your Debt Issues

Robert Hoffman of the Hoffman Law Offices is proud to offer an array of tax planning services. If you have concerns about your future tax obligations or tax law issues, schedule a confidential consultation with tax attorney Mr. Hoffman today by calling 800-897-3915 or contact the firm online.

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