There are two constants in life, death and taxes. And with the recent economic crisis, most people have added a third constant, debt. But getting out of debt is only the first, if the largest hurdle consumers face in their quest to become financially solid. Often times, dealing with the tax consequences of getting out of debt can land a consumer in more financial trouble than they were before they got rid of their debt. The tax consequences of getting out of debt depend largely on the type of debt relief program the consumer chooses.
Any kind of debt relief program where the consumer pays back the full amount of their debt causes no problems from a tax standpoint. These kinds of programs include budgeting, debt consolidation programs, and Chapter 13 Bankruptcy.
Choosing Debt Management Programs
When a consumer chooses a debt management program that involves the consumer only paying part of what they owe, the situation becomes more complex. Every time a creditor forgives part of a debt, that part of the debt becomes income to the consumer. This means that if a consumer negotiates a smaller payment in fulfillment of the entire amount due, has a part of the mortgage debt canceled in a foreclosure, or has their debt canceled as part of Chapter 7 bankruptcy, the consumer has income.
Depending on the source of the income involved, the company has two different forms that it must submit to the IRS, the consumer’s state taxing authority, and to the consumer. If the debt was forgiven in a foreclosure, then the mortgage company must send out a 1099-A and a 1099-C both of which need to be reported on the consumer’s income taxes for the year the debt was forgiven. If the income was from a settlement, then the company must only issue a 1099-C to the government and to the consumer. If a consumer receives just a 1099-C, then the amount of the debt forgiven should be reported on line 21 of a 1040 or 1040-A.
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What About Filing Bankruptcy?
Income from Chapter 7 bankruptcy is harder to report. According to IRS publication 908 the amount of income realized from the bankruptcy must be used to reduce certain tax attributes, which partially postpones taxes on canceled debt. Reduction of tax attributes is also required when a consumer is insolvent, meaning the consumer’s liabilities exceed the fair market value of their assets. If a consumer is insolvent, they may exclude any income from canceled debt to the extent of their insolvency.
In order to determine whether or not a consumer is insolvent, the IRS has developed a worksheet aptly named the Insolvency Worksheet. This worksheet requires the consumer to list every asset and debt, the fair market value (FMV), and the amount of their debt. The sum of the FMV of every asset and the total amount of all a consumer’s debt has to be added together and then subtracted at the bottom. After determining whether the consumer is insolvent, and by how much, the consumer must then report the amount by which they are insolvent on form 982.
If a consumer has gone through bankruptcy, the amount of the debt is also reported on Form 982.
Forgive Your Debt
Every consumer should realize that once they have been forgiven debt, declared bankruptcy, or are claiming they are insolvent, they will not be allowed to file using a 1040 EZ. This will increase the cost of filing income taxes if the consumer chooses to seek professional assistance.
This is a guest post from Caroline Palmer who is an associate attorney with OVLG. Caroline is not endorsed or affiliated with LPL Financial.
This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. We suggest that you speak with a qualified tax advisor for specific tax advice.