Loan forgiveness? Great, but beware the tax.
Loan forgiveness is helping indebted Americans. But the amount of the loan forgiveness can be taxed by the IRS.
Reminders of the financial crisis – little slips of paper called 1099-Cs, the Cancellation of Debt form – have been hitting mailboxes in time to create a few more headaches during tax season.Skip to next paragraph
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How could anyone possibly owe more taxes if they couldn't pay their bills in the first place and needed to have a debt forgiven by a lender?
Well, that's exactly what some consumers are asking.
Many people who found themselves overburdened by debt are now looking at some complex tax rules when they receive a 1099-C, a tax document issued by lenders when a car loan, credit card bill or other debt of $600 or more is forgiven or canceled.
The good news, though, is that there continues to be a limited tax break now related to foreclosures.
The Internal Revenue Service projects 6.3 million 1099-Cs will be issued for the 2011 tax year. That's up about 60 percent from the previous year's number.
Detweiler said some consumers are shocked to receive a 1099-C for a very old debt – say, 10 years old. But it might be that the financial firm is now saying the debt is uncollectible.
Other consumers are swearing the amount is wrong and includes inflated fees or a debt that was discharged in bankruptcy.
Some students have had student loan debt canceled because of a disability but are surprised to learn that they may owe taxes on a forgiven amount.
"I just had a guy write in who says they'll likely get a divorce over this," Detweiler said.
The 1099-C can be quite confusing – and unsettling – but it's something taxpayers cannot ignore.
Loan forgiveness for the most part is treated just like income and must be reported as income on state and federal income tax returns.
It's as if you received extra money from a second job or won big on a lottery ticket, which in a way you sort of did. You did get a break when you no longer owed the money.
But not all 1099-Cs lead to higher taxes.
For example, you'd still get a 1099-C on a foreclosure. A limited, special provision does allow up to $2 million of canceled debt on a mortgage to be excluded from income, but only on a principal residence and only if a foreclosure or short sale took place from 2007 through 2012.
In this case, the canceled debt must have been incurred to buy, build or improve your main home. Not to refinance to pay off credit card debt.
If you faced foreclosure on your vacation property, you would have to report that forgiven debt and would owe taxes on it, too.
Taxpayers might need to look at Form 982 – "the reduction of tax attributes due to discharge of indebtedness" – to fully understand the rules.