Cancellation of Debt

Tom Tosuksri, Cleveland Housing Network

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Cancellation of Debt• Cancellation of Debt is reported on Form 1099-C• Debt cancellation occurs when the Taxpayer has

a Loan or Obligation to a Lender, in which the Lender works with the Taxpayer to forgive all or part of it

• The most common sources of Debt Cancellations:o Foreclosure on a homeo Auto Loano Student Loano Credit Card

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Cancellation of Debt• Depending on the circumstances, the Taxpayer

may have to include the cancelled debt as income

• The cancelled debt would be considered “income realized” that was used to “pay” the debt although no transaction occurs

• The taxpayer may be protected by the Mortgage Debt Relief Act (for principle mortgages cancelled/reduced between 2007-2013) or the Insolvency Provision

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Dealing with 1099C• Step 1: Determine if C.O.D. income makes a

difference:o Does adding it change the refund or amount due?o Combined with other income, is it more or less than the Standard Deduction

and all exemptions?o I.E. A taxpayer earning $2,500 in wages with a $5000 debt cancellation will

not have a tax liability thus can go ahead and include it as income

• Step 2: Do they qualify under the Mortgage Debt Relief Act?o Was the debt cancelled between 2007 and 2013? (not extended to 2014)o Was it due to a foreclosure on a Main Home?

• Must have owned home for 2 years• Must have lived there for 2 out of last 5 years

o File form 982, select option 1e• Total amount of discharged indebtedness: Cancelled Debt• Applied to reduce the basis: Fair Market Value

o Complete Capital Gain for sale of home using Sch D Wkt 2, Form 8949, and Capital Gains Wkt.

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Dealing with 1099C• Step 3: Determine if Taxpayer is Insolvent

o PLEASE NOTE: Insolvency calculations are a function of Certified Public Accountants and Tax Professionals and are not to be completed by VITA volunteers. Please refer taxpayers to Legal Aid to complete the insolvency form upon discovery that they may be insolvent

o Insolvency is when the taxpayer has more liabilities than assets. Basically, if the taxpayer sells everything he/she owns, they still would not have enough to cover debts.

o Assets include: Houses, Cars, Cash, Property, IRA’S, 401K’s, Life Insurance Policies, Investments, among other items

o Liabilities include: Mortgages, Auto Loans, Personal Loans, Student Loans, Past Due Medical Bills, Utility bills, among other items

o Please review IRS Publication 4861 for a detailed listing of items and consult a Certified Public Accountant

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Dealing with 1099C• Step 3: Determine if Taxpayer is Insolvent

o Insolvency is determined at the date the debt is cancelled, not today’s date. Taxpayers are typically advised to collect this information on the date it is cancelled.

o Use IRS’s insolvency worksheet to give an estimate. ALWAYS refer taxpayers to Legal Aid to determine official insolvency.

o http://www.irs.gov/pub/irs-pdf/p4681.pdf• Insolvency Worksheet, Page 8

o Once a professional has reviewed insolvency and made that determination, the return can be completed. The debt can be excluded using Form 982, option 1b

o The amount of debt that can be excluded is less than or equal to the amount insolvent. • A taxpayer with $100,000 in Liabilities and $90,000 in Assets can

exclude up to $10,000 in cancelled debt, the difference.

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