Debt Cancellation Overview
Debt cancellation occurs when a creditor forgives all or part of a person’s debt. When creditors do this they usually have to write off the debt as a loss and report it as such, and for this they get certain tax benefits. Debt cancellation can happen with credit card debt, mortgages, personal loans and with medical expenses. Here are some examples to illustrate this.
If you owe so much on a credit card and have been behind on your payments for so many months, your credit card company or a collection agency to which your account was referred, could offer you a one-time reduced payment to close the account and cure your debt. If you take them up on the offer, for example a one-time $1,500 payment for a $7,000 credit card debt, your debt would be considered cured and you have basically received a debt forgiveness in the amount of $5,500.
In this article, we address debt cancellation of homeowners dues and the potential tax impact.
Debt Cancellation of Homeowners Dues
Debt relief can often come in the form of some sort of debt cancellation of homeowners dues. These could be a reduction in the total amount due for a home in foreclosure in the form of a short sale or loan workout. It could also come in the form of relief on property taxes from your city. Here is a common example. If you have a home you originally borrowed $400,000 to buy and is now valued at $250,000 because of the housing slump, the bank may be willing to accept $250,000 from a new buyer in the form of a short sale and you will owe nothing after the sale.
Tax Consequences of Debt Relief
In the short sale example above the bank will write off the forgiven part of the debt as a loss and reserves the right to pursue a deficiency judgment against you. Even if the bank does not do that it is required by law to report any debt write off that is $600 or more. Therefore in this case it will report the forgiven part of the loan as income to you. You will most likely receive a 1099 from the bank, which is an IRS form used to report miscellaneous income. In our example, the forgiven amount of $150,000 will be reported to the homeowner as income on a 1099-C.
If you are in this situation you may be able to avoid paying income tax on this amount if handled properly. Make sure to talk to a tax professional to get specific advice that will apply to your own particular situation. Generally, if you are able to show that you were insolvent at the time the debt was forgiven, you will not be required to report it as income or pay income tax on the forgiven amount. Insolvency means your liabilities were more than your assets at the time you received debt relief. You can also file insolvency with the IRS by filing IRS Form 982.