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Credit Card Settlements Can Trigger A Tax Bill…

March 11, 2011

When a client gets their taxes done and they owe money that they were not expecting to owe, the world seems to fall apart. You see it in their eyes, you hear it in their breathing and their shoulders are not as buoyant Forgiven debt such as a credit card settlement or foreclosure can trigger a tax bill. …Sandra Block of USA Today describes it the best. “Getting a tax bill after you’ve gone through foreclosure is like having a bucket of ice water poured over your head after someone has made off with your pants.” You’ve lost you’re home and probably don’t have much money, so why would you owe the IRS anything?

Here is why: The IRS treats forgiven or canceled debt as taxable income. For example, suppose you owe $400,000 on a home that goes into foreclosure, the bank sells it for $300,000 and writes off the rest of your loan. Under the tax code, the $100,000 in forgiven debt is taxable income. In 2007, Congress enacted legislation that excludes up to $2 million in forgiven mortgage debt from taxes, as long as the loan was used to buy or improve the taxpayer’s primary residence. That means that most people who lost their homes to foreclosure last year won’t have to pay taxes on the canceled debt. There are limits,though, to this relief. The exclusion is scheduled to expire at the end of 2012, which means homeowners who are starting to fall behind on their payments could face a nasty tax surprise in 2013. And individuals who have had other types of debts forgiven by their lenders could be in trouble right now.

Financial institutions that wrote off debt of $600 or more are required to send a Form 1099-C to the borrower and the IRS. If you receive a 1099-C for debt that was forgiven as a result of a foreclosure, you need to inform the IRS that it qualifies for the exclusion. To do this, fill out Form 982 on your Form 1040 and check Part 1, box 1E. Otherwise the IRS may treat your forgiven debt as taxable income. And there’s plenty of forgiven debt that falls into that category, including:

  • Credit card debt
  • Student loans
  • Mortgage debt from a second home
  • A second mortgage or home equity line of credit that wasn’t used to improve your home

Even if your forgiven debt doesn’t qualify for an exclusion, taxes aren’t inevitable. Individuals facing tax bills on forgiven debt have two options: File for bankruptcy or Prove insolvency (the IRS will reduce or eliminate taxes on forgiven debts if you can demonstrate insolvency). If all you own is a car and a savings account, proving insolvency may be straightforward. But if you are like most families, you own other assets, such as retirement savings, jewelry and life insurance policies. Not so easy then. Please give GAI ( a call at 212-979-6830 or stop by for a visit as we can help you. We know that life is hard and financial issues can be overwhelming. We are here to help you through those trying times. Our office is open Monday through Friday 8am – 8pm and Saturdays 8am – 5pm. See you soon!

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