If you were among the millions of Americans who were hit hard by the economic meltdown, you no doubt understand the struggle to pay your mortgage or having to spend hours negotiating your credit card debt with your lender. We've seen many taxpayers who are still trying to get their finances on solid ground after a foreclosure or getting some credit card balances wiped out.
Credit Card Debt Is Income
If this is you, there's a sort of double whammy: don't be surprised by how all of these transactions will impact your taxes. Many people don't realize that canceled debt is often treated as taxable income by the IRS. If, for example, you carried a $10,000 credit card balance, and you lender agreed to forgive $5,000, you may be taxed on the canceled amount. The rationale is that you borrowed the money with an agreement to pay it back. If the agreement is voided and you are no longer paying back all the debt, the forgiven amount is free money-;income. Never mind that it may be long gone; the taxman wants his share. If you receive a 1099-C notice regarding canceled debt from credit cards, this could pertain to you.
On the other hand, you may be exempt from paying taxes on a portion or full amount of those funds. By IRS standards, those whose liabilities exceeded their assets when the debt was settled were considered to be insolvent, which may mean you don't have to pay on forgiven debt.
It's smart to check with your tax pro so there are no surprises.
The Cost of Foreclosure
Another complicated issue is foreclosure. This isn't just heartbreaking; again you may also get hit with a tax bill.
The IRS treats foreclosure as a sale of a property, meaning that owners may not only be required to pay capital gains on the "sale," but also on income in the form of canceled debt, depending on whether they carried a recourse vs. non-recourse loan.
Recourse or Non-Recourse Loan
If you have signed a recourse loan, this means you are personally liable for the debt, and lenders may pursue repayment following the foreclosure. In a recourse mortgage, the lender can go after the borrower's other assets. Those with non-recourse loans are not legally liable for their balances. Instead, lenders repossess the property to secure the loan.
To determine capital gains or losses, the basic formula involves subtracting the adjusted basis of the property -;typically the purchase price plus any home improvements-; from the lesser of fair market value of the property or the outstanding loan balance prior to foreclosure; or, for non-recourse loans, the outstanding loan balance immediately prior to the foreclosure.
If this results in a gain, and the borrowers owned and used the home as their primary residence for at least two years during the five-year period ending on the date of foreclosure, they may qualify to exclude up to $250,000 from income reporting requirements. This amount increases to $500,000 for married couples filing jointly.
Canceled debt is stressful enough. Not knowing the consequences can add to that stress, which is why it's wise to have a professional walk you through your options.
The goal is to rebuild and start again. One of my key business principles states that mistakes are a wise person's education. Everyone gets knocked down; winners get back up.