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Friday, January 29, 2010

Cancellation of Debt

The current economic times have impacted many credit card users. In some cases, borrowers have renegotiated credit terms and/or had credit balances reduced. Often, the borrower is surprised to learn that the reduction in a credit balance may be taxable income.

To understand the logic of this tax law, follow the transaction from inception. When a person borrows money from a commercial lender, the loan amount is not counted as income since you have an obligation to pay it back. When part or the entire loan is forgiven, you don’t have to pay it back. The bank gave it to you. Therefore, the forgiven amount is income. The lender reports the amount of cancelled debt (the amount you no longer have to repay) on Form 1099-C, Cancellation of Debt.

Here’s a very simplified example. You have $10,000 in credit card debt. You have been having difficulty making your monthly payments. You negotiated with the lender and agreed to pay $6,000 on an installment schedule. The lender has forgiven $4,000. This $4,000 is taxable income. The lender will report the amount to you and the IRS on a Form 1099-C, Cancellation of Debt.

Cancelled debt is not always taxable. Debts discharged through bankruptcy are not considered taxable income. Additionally, if you are insolvent, some or all of the debt may not be taxable. You are insolvent when your total debts are more than the value of your total assets. Insolvency can be difficult to determine and the help of a tax professional is recommended.

Mortgage debt is a special case. The Mortgage Forgiveness Debt Relief Act of 2007 generally allows a taxpayer to exclude from income debt forgiven on the mortgage on his principal residence. This act applies to mortgage debt forgiveness from 2007 through 2012. Debts reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. If the taxpayer remains in the home, the forgiven amount reduces the taxpayer’s cost basis in the home.

IRS Circular 230 Disclosure

Pursuant to U.S. Treasury Department Regulations, we are now required to advise you that any federal tax advice contained in this communication, including attachments and enclosures, is not intended by the Sender or Sandra G Johnson, CPA, P.C. to constitute a covered opinion pursuant to regulation section 10.35 or to be used for the purpose of (i) avoiding tax-related penalties under Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein.


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