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Debt Cancellation...Income?

"I received a 1099-C.  What is this and do I really have to include this as income on my tax return?"

     This question is one of the more common ones asked by our clients recently.  In light of the current economic situation, more and more people are getting behind on their mortgages, car loans, or other personal loans.  I am seeing more billboards and tv commercials than ever before for loan modification and bankruptcy attorneys.  Many people rush too quickly into the decision for bankruptcy or loan modification without really understanding the full tax consequences.  And what's worse is that many of the very people advertising these services aren't fully aware of the tax implications either.  Scary?  Yes!

     Many people don't understand that if you have debt forgiven, the IRS treats the amount forgiven as income received in the period in which it was forgiven.  This means that in many instances you could pay income tax on income that you never "saw"!  Many people are confused by this.  They think, "I never received any cash from my short sale or foreclosure, and in fact I'm worse off because I lost my house, so what am I paying taxes on?"  To answer this question, you have to look at the whole transaction from the perspective of the IRS and lender, as well as from the perspective of the individual.  We won't address this today, but the fact of the matter is that the individual receives the benefit of not having to repay the loan, and that has historically been deemed as income (if you want to discuss this part further, please call us and we can set up a time to discuss it in greater detail).

     Because so many people were finding themselves in this situation, Congress enacted the Mortgage Forgiveness Debt Relief Act at the end of 2007.  This act provides relief to some of these people.  The basic point of this act is that it generally allows taxpayers to exclude from income any cancelled debt from their principal residence.  So if taxpayers have had the bank foreclose on a personal residence and then send them a 1099-C, this amount could be excluded from income in some instances.  This exclusion applies to debt forgiven from 2007-2012, and has a cap at $2 million (or $1 million if married filing separately).  Of course, there are too many circumstances to be able to cover in one entry, so please contact us if you are in a similar situation and have further questions.  We can help guide you through the process and help you decide which course of action is the best for you.  

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