Short Sales, Cancelled Debt, Taxes and Bankruptcy

by Adrian Lapas, Esq.

November 4, 2011

The latest recession has spawned a whole industry of websites crowing about how to properly deal with too much debt.  For example, if your house is worth less than what you owe on your mortgage, perhaps a website will promise to negotiate a short sale–that is, the lender will accept less than the pay-off but will release the mortgage on the property.  Or, as another example, if you owe a lot in credit card debt, the website will promise to reduce your balances or “settle” the credit card accounts for less than what is owed.  Unfortunately, many of these websites or “programs” omit to tell you one very important detail:  tax implications!

When debt is cancelled or forgiven, the creditor must report the amount of debt cancelled or forgiven to the IRS through a Form 1099-C.  The amount of forgiven debt is then attributed to you as “income” for tax purposes.  This means that if you have a credit card or mortgage (more on this later) and $20,000.00 is cancelled or forgiven, then you will receive a Form 1099-C for that amount and it will also be reported to the IRS.  When you figure your taxes, basically, your income will increase by the amount of the forgiven debt.

So what does this really mean?  Potentially, if you are a single filer and, before you include the amount of cancelled debt, your adjusted gross income is $48,000.00, you will be obligated to pay $8,188.00 in taxes according to the 2010 tax tables.  But, if you had debt cancelled of $20,000.00, then, potentially, your adjusted gross income is $68,000.00.  This is because you add the $20,000.00 in cancelled debt to your income.  You would then be obligated to pay $13,188.00 in taxes–$5,000.00 more!!!  Of course, this is a simple example and for a lot of folks, cancelled debt may or may not make a big impact on their tax liability but nevertheless, the impact can be real and significant!

There are exclusions to the cancelled debt being included in your taxable income.  The exclusions are contained in the Internal Revenue Code under Title 26 of the United States Code at Section 108.  See here.  The biggest exclusion is (A) “the discharge occurs in a Title 11 case” which is bankruptcy.  If debt is discharged in bankruptcy, it is not attributed to you as income.  You may still receive a Form 1099-C but you can include another form with your tax return.  See here for a Form 982 and see here.

There is another major exclusion that is geneally applicable to consumer debtors.  If the cancellation of the debt occurs while the debtor/taxpayer is insolvent, then you may reduce the amount of the cancelled debt from your gross income.  See 28 U.S.C. § 108(a)(1)(B).  This may require substantial documentation of your insolvency.

Another major exclusion that is particuarly relevant to short sales is set forth under (a)(1)(E).  This provision states that if you have cancelled debt that stems from the a qualified principal residence, then the cancelled debt will not be included in your income for tax purposes.  So, if you negotiate a short sale for $50,000.00 less than what you owe on your home, under this provision of the tax code, the amount of the cancelled debt will not count towards your income for tax purposes.  HOWEVER–this provision expires at midnight on December 31, 2012!  If a mortgage creditor is negotiating with you for a short sale, be sure to include a cancellation of indebtedness in the negotiation.  If the cancellation comes after January 1, 2013, you could be facing a big tax liability if some other exclusion does not apply.

As you can see, negotiating debt issues can be a minefield just waiting to blow up in your face.  While bankruptcy may not always be the best option, it is certainly worth discussing your debt issues with a qualified, experienced bankruptcy attorney to explore your options.

 

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Adrian Lapas, Esq.

I've been practicing bankruptcy law in North Carolina since 1993, and am certified as a specialist in consumer bankruptcy law by the North Carolina State Bar.

Last modified: November 4, 2011