Tax Debt Forgiveness
Often people fall on hard times and stop paying on credit cards. After a while the account may go to an outside debt collector who might offer a settlement of the debt for 30-40% of the original sum. Once this is paid, the debtor often thinks the matter is closed, but it is not! It is very likely that the creditor will issue a 1099-C. This is a notice to IRS of the forgiven debt. If the debtor does not address this on his return he may get an IRS bill a year or two later with penalties and interest.
But before you pick up the phone and sign your life away, it’s important to understand that there can be major tax consequences to having your debts forgiven. More than a few consumers have had significant debts canceled, only to find out that their forgiven balances count as additional taxable income on their annual returns. In a worst-case scenario (someone in one of the top tax brackets), the resulting IRS bill could easily be $300-400 for every $1,000 forgiven.
A foreclosure on a home may also result in a 1099-C from the mortgage lender if the property is sold for less than the amount of the loan. In this instance, a person loses their home and may also face a tax bill. Usually, the bill comes many months after the tax return was filed as a result of an IRS document matching program. This “under-reporter” notice brings grief to the taxpayer.
One of the things to consider in any of these is what happens to the excess debt. For example, if you have a loan on your property of $400,000 and it’s only worth $250,000 now and the company either allows a short sale or a principal reduction to that amount, there is $150,000 still to figure out what to do with. In some cases, the company isn’t allowed to come after you for the debt. (That’s called getting a deficiency judgment.) In many cases, though, people thing they’re exempted and they’re not. In fact, under most state law the lender has up to 4 years to file against you.
When you seek IRS debt forgiveness, your situation will be referred to as an ‘uncollectible status’. When this status is in application, the IRS simply gives up on collecting dues from you and allows you to time to get back on your feet. This is not a permanent solution but this can cause a huge sigh of relief for taxpayers in question, as his or her property will not be seized due to unpaid taxes. Bank and wage levies will be avoided as well. To obtain this status, you need to file a 433A if you are an individual and 433B if you owe business tax. You will be required to show that whatever you earn is barely enough to support you and your family. If you are flush with cash, you will get no relief.
Deciding to Settle
There’s no doubt that adding in a complicated tax discussion can make a debt settlement decision feel even more overwhelming. Not only do you have to consider the effects of the debt settlement on your credit score and available cash, but you also have to decipher whether or not a tax bill will make an already difficult situation worse. If you’re going to owe the IRS big money, you’ll want to think about it much more carefully. In hindsight, many people who have been unable to pay their tax bill from a settlement have realized that it’s far more preferable to have general creditors breathing down their necks than it is to be in the spotlight of the IRS.
One last thing to know is that the tax code extracts a price for allowing those who are in bankruptcy or insolvent to exempt their COD income from taxation. So-called tax attributes that these taxpayers have, such as capital loss carryovers, tax credit carryovers, and the tax basis of certain assets (used to calculate tax gains and losses and depreciation deductions) may have to be reduced. See IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness), which must be filed with your federal return. You must also file Form 982 if you take advantage of the home mortgage exception.
If you have had debt forgiven, you will almost certainly need the help of an accountant or lawyer specifically knowledgeable about this dark alley of the tax code. The problem being that those sorts of experts don’t work for free, and if you are broke enough to have debt forgiven, then, well, you get the idea.