Tax Issues Associated With Forgiveness of Debt Income

Tax Issues Associated With Forgiveness of Debt Income

By Jay Choi, CPA

With the mortgage crisis showing little sign of abating in the near future, an increasing number of banks are engaging in mortgage workouts and debt forgiveness. The federal government has provided tax relief for forgiven mortgage debt through 2012. Author Jay Choi explains the relief provisions and the obligations of banks and taxpayers.

Debt relief normally results in taxable income for the debtor. Under the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA), though, taxpayers may exclude debt forgiven on their principal residence in some circumstances. The legislation was originally enacted on Dec. 20, 2007, for 2007 through 2009 and was extended through 2012 in October 2008.

Qualifying Debt
The legislation generally allows taxpayers to exclude income from the discharge of debt on their principal residence if the balance of their loan was less than $2 million (or $1 million for a married person filing a separate return). Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for relief. The discharge must occur either because of a decline in value of the principal residence or because the taxpayer is in poor financial condition.

The MFDRA applies only to forgiven or canceled debt used to buy, build, or substantially improve the principal residence or to refinance debt incurred for these purposes. In addition, the debt must be secured by the home. This is referred to as “qualified principal residence indebtedness.”

Debt forgiven on second homes, rental property, business property, credit cards, or auto loans does not qualify for the tax relief. The exclusion also does not apply if the debt discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

Filing Requirements
The taxpayer must report the amount of debt forgiven on Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment),” which must be attached to the taxpayer’s federal income tax return. The taxpayer completes the form based on information from Form 1099-C, “Cancellation of Debt,” provided by the lender.

A bank must file Form 1099-C, or, in the case of foreclosure or repossession, Form 1099-A, “Acquisition or Abandonment of Secured Property,” for each debtor for whom it canceled any debt of $600 or more. Form 1099-C must be filed regardless of whether the debtor is required to report the debt as income. The bank should not file the form when fraudulent debt is canceled due to identity theft and the debtor is not liable for the debt. Also, the bank generally would not file the form for a discharge of indebtedness under Chapter 7 bankruptcy. Additionally, a Form 1099-C does not need to be corrected because of any payment made by the debtor subsequent to the filing of the form.

When Forms 1099-C and 1099-A Overlap
If a bank cancels a debt in connection with a foreclosure or abandonment of secured property in the same calendar year for a single debtor, it is not necessary to file both Form 1099-A and Form 1099-C for that debtor. The bank can file Form 1099-C only. The Form 1099-A filing requirement for the debtor is satisfied by completing boxes 5 and 7 on Form 1099-C. A bank may choose to file both Forms 1099-A and 1099-C; if so, it should not complete boxes 5 and 7 on Form 1099-C.

Jay Choi is a manager with Crowe Horwath LLP in the Oak Brook, Ill., office. She can be reached at 630.575.4261 or jay.choi@crowehorwath.com.

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Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.