Will I Be Taxed On Forgiven Debts?

My clients are frequently able to have their debts forgiven through a bankruptcy, a foreclosure, or a short sale.  A common question that comes up is whether taxes will be owed on the debts being forgiven, i.e. mortgages, credit card debt, and medical bills.  This is a great question.  Under the Internal Revenue Code (26 USC § 61(a)(12)), gross income includes income derived from the discharge of indebtedness.  The tax code can be daunting in its complexity.  For those brave enough to venture into that maze, I have attached a few references that you can click on to read the Code itself.  The references are accurate as of the date of this post.  In general, here is a summary.

The Internal Revenue Code contains a few exceptions to the taxation of forgiveness of indebtedness in 26 USC § 108(a)(1).  They include a discharge in Bankruptcy (chapter 11) and a discharge when the taxpayer is insolvent and not bankrupt.  Up until January 1, 2014, there was also an exception for a discharge of qualified mortgages on the taxpayer’s principal residence.  We are still hopeful that Congress will pass a bill to reinstate that exception later this year.  A discharge through a Bankruptcy case is pretty straightforward.  However, there are some wrinkles in the insolvency and acquisition indebtedness exceptions.  Here are some examples.  In anticipation that Congress will reinstate the qualified mortgage exception, I have included some issues concerning that exception as well.

      • If a taxpayer negotiates a settlement over credit card debts, the amount forgiven is initially taxable.  However, if immediately before the settlement the taxpayer’s total indebtedness was greater than the fair market value of all of the taxpayer’s property (even 401k’s), then the insolvency exception would take the debt forgiven out of the taxpayer’s taxable income up to the amount of the insolvency.  The taxpayer would likely receive a 1099 form from the credit card companies disclosing the forgiveness income.  However, the taxpayer would then file IRS form 982 to exclude the income.  As an example, if the taxpayer settled with credit card companies and received a discharge of $50,000 and at the time had assets with a fair market value of $300,000 and total debt of $330,000, then the taxpayer would be able to exclude $30,000 of the $50,000 debt forgiven.
      • When part or all of a mortgage on a taxpayer’s principal residence is forgiven through a foreclosure process, or deed in lieu of foreclosure, or a short sale, the taxpayer may be able to use the insolvency exception discussed above to exclude the resulting income up to $2 million. If the insolvency exception does not apply and the taxpayer has not obtained a Bankruptcy discharge, then our fingers are crossed that Congress will reinstate the qualified mortgage exception.  That exception applies when the debt being forgiven was “acquisition indebtedness,” which is defined under 26 USC § 108(h)(2) and 26 USC § 163(h)(3)(B) as debt incurred to acquire, construct, or substantially improve a taxpayer’s principal residence and that is secured by the taxpayer’s principal residence.  The exception applies to refinanced mortgages as long as the refinanced mortgage is for the original acquisition indebtedness.  So, if a taxpayer gets a second mortgage on the taxpayer’s principal residence to start a business or take a trip or do anything other than acquire, construct, or remodel the residence, and later the mortgage is forgiven, the taxpayer could very well end up owing tax on that forgiven debt since the qualified mortgage exception would most likely not apply.  KEEP IN MIND: Right now there is NO qualified mortgage exception.  Unless Congress reinstates this exception, if a taxpayer gets a discharge of a mortgage and the taxpayer is not insolvent and has not gotten a Bankruptcy discharge, the forgiven mortgage is taxable.

Discharging debts is an important aspect of what Basham Law Firm does for its clients.  Call today for a free consultation at (541) 385-0914.

The foregoing brief summary is not intended as legal advice as to a reader’s particular situation and should not be relied upon for that purpose.  Furthermore, to comply with regulations of the Internal Revenue Service, we are required to inform you that this communication, if it contains advice relating to Federal taxes, cannot be used for the purpose of (i) avoiding penalties that may be imposed under Federal tax law, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication.