Tax Tip of the Week
A Look at "Cancellation of Debt" Income
So, You Think You Are Out of Debt?
In these difficult financial times and declining home values, we have helped numerous clients navigate the tax issues of Cancellation of Debt (COD). A COD is created when a taxpayer sells their home in a short sale (sales price is less than the mortgage amount), has a property foreclosed upon, or settles a credit card debt for an amount less than the current balance.
What most people don’t realize is that the IRS considers COD taxable income. The lender will issue a 1099-C to let the IRS know that a COD has occurred. Credit card companies in particular are very lax in informing their card holders that COD is taxable income.
Fortunately, the Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from a COD if the debt is on their principal residence. Also, the COD income could be excluded if discharged in a bankruptcy procedure.
Important Notice - The COD exclusion for primary residences will expire 12/31/2012. At this time, we have no clue if Congress will extend this provision of the tax code. Homeowners could still be on the hook even if the house is sold but the bank does not formally forgive the remaining balance of the loan in a letter. The bank must officially sign off in writing before December 31, 2012.
If the COD occurs on a second home, a rental property, or a reduction of a credit card balance, then the taxing implications can only be reduced if the taxpayer can prove insolvency. Insolvency is proven by completing a worksheet like the one found on page six of Publication 4681 . On a worksheet like this, you must list all assets and liabilities at the time of the COD. The COD income can then be excluded from taxation only to the extent of the insolvency (the amount that debt exceeds assets).
This Tax Tip is only a very brief overview of a very complicated piece of the tax code and should not be relied upon for every situation. We strongly urge you to call us if you know of anyone in this situation. It may also be advisable to consider a short sale of a primary residence now due to the uncertainty of the 2013 tax laws.
As always, give us a call if you have any questions.
You can contact us in Dayton at 937-436-3133 and in Xenia at 937-372-3504. Or visit our website.
Rick Prewitt - the guy behind TTW
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