Tax Settlement Overview
For someone struggling to pay off major liabilities such as consumer loans or a mortgage on a home, one would think, cancellation of that liability by the lender would be cause for celebration. The cancellation of a liability often suggests a default has occurred and the lender has decided not to pursue legal proceedings to collect on that liability. However, a cancelled liability will frequently lead to unintended tax issues with the IRS, which are treated as income by the IRS and thus taxable.
Generally, a tax settlement liability (whether business and/or personal tax liability) is associated with an obligation to repay the liability at some time in the future. But if a liability or any portion thereof is forgiven (often referred to as cancelled or discharged) for less than the amount owed, that portion of the liability forgiven is treated as taxable income.
Forgiven Liability Examples
Forgiven liabilities are most frequently associated with consumer credit cards, home loans or business loans. Examples of forgiven liabilities are 1.) When a creditor is no longer pursuing the amount owed due to their inability to collect it and has written off the liability on their books. 2.) A lender has foreclosed or modified the terms of a mortgage. 3.) A voluntary transfer or abandonment of property.
With few exceptions, taxpayers have taxable income related to a forgiven liability which must be reported on their tax return for the year the liability is forgiven. As a result, the lender/creditor will issue the taxpayer a form 1099-C at the end of the year indicating the amount of the liability forgiven and that it was cancelled or forgiven in the year in question. In most cases taxpayers are required to report the forgiven liability as ordinary income on their tax return in accordance with the form 1099-C. When the form 1099-C is issued the creditor can’t continue to pursue collection of the liability.
Recourse vs. Non-Recourse
For property secured by a loan which is foreclosed or taken by a creditor for satisfaction of the loan either in whole or in part the treatment of that event will be predicated upon whether your personally liable (recourse) or not (non-recourse) for the loan.
There are exclusions regarding the requirement of including forgiven loans as income. Examples include student loan cancellation meeting specific requirements is eligible for being excluded as income as well as a forgiven loan received as a gift or inheritance. Other examples of exclusions include qualified farm and or qualified real property business liabilities and a liability cancelled in a Title 11 bankruptcy proceedings. To qualify, the forgiveness of the liability must be a result of the court granting it or as part of a plan approved by the court. Also, if a taxpayer is insolvent prior to the forgiveness of the liability this should not be included in income either but to do so the taxpayer must provide supporting documentation that he/she was insolvent.
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