Debt forgiveness is a fantastic thing for most people, as it means less than the whole of a debt has been paid though the debt has been satisfied. However, it’s considered taxable income and the lapse of a debt forgiveness tax break for foreclosures or short sales of homes is set to bite some taxpayers.
Debt forgiveness does not get one off the hook from Uncle Sam
Millions of people breathe sighs of relief every year when granted debt forgiveness. Also called debt relief, debt cancellation, it’s where a loans lender of some sort, like a credit card company, mortgage lender or whomever, agrees to forgive a debt if the borrower, perhaps in dire straights, agrees to pay off a portion, usually on a condensed payment schedule.
Then they get the bad news which is, according to the Wall Street Journal, that debt forgiveness is taxable income. The way it works is that since the portion that’s forgiven is technically a bonus toward one’s personal petty cash, that’s income.
Ergo, it’s taxable and forgiving lenders have to provide a tax form, a 1099-C, that borrowers have to report on tax forms.
Forgiven mortgages included
Debt forgiveness taxes can be a real kick in the nether regions when connected to mortgages. When a home loan lender forecloses on a house and either forgives the debt, reduces the principle or agrees to a short sale, the fair market value and forgiven debt for the home have to be reported on a 1099-C. However, the tax on it, for some, is exempted for the time being.
In 2007, the government passed a law exempting certain foreclosed-on homeowners from a portion of this debt. The law, the Mortgage Forgiveness Debt Relief Act, also extends, according to CBS, to people who participated or are participating in the Home Affordable Modification Program or HAMP, who received a principle deduction or other modification that would otherwise be subject to the tax.
However, according to the Wall Street Journal, it only applies to mortgages to “buy, build or improve” a primary residence. Second-home mortgages are not eligible, so in your yuppie faces.
Will be a headache next year
That law was set to expire last year, but was saved in the “fiscal cliff” negotiations. However, it will lapse before 2014, unless extended. That said, as CBS points out, debt forgiveness for mortgages can be claimed over a period of three years or all it once – forgiven homeowners who haven’t claimed it yet should claim it all this year and reap the benefit of the exemption, if applicable.
More people are receiving debt forgiveness or debt cancellation from lenders than ever. According to Creditcards.com, just over 1 million 1099-C forms were filed with the IRS in 2003, rising to 2 million by 2006 and nearly 4 million in 2010. It’s projected that in 2013, the IRS will receive close to 6.5 million debt cancellation tax forms.