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"Forgive us Our Debts?"

You settled credit card debts for an amount that is less than what you owed. 

You sold your house in a “short sale” and one or more lenders forgave part of the debt that you owed them.

Your residence was sold at a foreclosure sale for less than what you owed the lender.

When a commercial creditor forgives or cancels your debt owed to them by writing off the debt, such may be deemed income to you depending on the circumstances.  The Internal Revenue Service (IRS) may consider debt that is written off by the creditor as income to you even though you did not receive money or property in exchange.   The commonly stated rationale for this law is that you gained income because you no longer have an obligation to repay the lender.  But to learn the primary actual reason for being taxable, click here.

The law requires a creditor to issue an IRS Form 1099-C (Cancellation of Debt) to any individual person who settles a debt or has a debt written off that is in excess of $600.   If you have received a Form 1099-C from a creditor, the amount declared on that form is, in many cases, considered income...Taxable income!   However, there are exceptions to this rule which will be discussed further below.


You settle a particular $10,000 credit card debt for $6,000.  You later receive a Form 1099C in the amount of $4,000.  Unless an exception applies, you will have to declare that $4,000 savings as income on your tax return. 

You elected to do a short sale on your personal residence (or alternatively your house was foreclosed and sold; or your loan was modified).  Later you receive a 1099-c with $120,000 of canceled mortgage debt.  Unless an exception applies, you will have to declare that $120,000 of mortgage relief as income on your tax return. 

There are at least four exceptions to the above income rule.  The first two apply to most types of debts. 

1. Insolvency Exception.  If you are “insolvent” at the time the debt is written off, you will not owe the tax.  Essentially you are insolvent if the amount of your total debts owed exceed the fair market value of your total assets owned.  

2. Bankruptcy Exception.  If you file bankruptcy before the debt is written off and the 1099C is issued, there is deemed, by operation of law, to be no income to declare. 

3. Prinicipal Residential Real Estate Exception.   The Mortgage Forgiveness Act of 2007 applies to residential (owner-ocupied) homeowners of real estate who had the debt written off or restructed during the 2007 to 2012 calendar years.  Rental properties, second homes, and vacation homes do not qualify under the Act.  The Act protects a homeowner from debt cancellation up to $1,000,000 or up to $2,000,000 for a married couple.  Further, to qualify under the Act, the forgiven loan must have been used exclusively for home purchase or improvement.

4. Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed. Stated another way, in a non-recourse type of loan, the lender cannot elect to pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.  

California Code of Civil Procedure (CCP) Section 580b and certain other states laws make certain types of residential loans non-recourse by law (that is, loans used to actually purchase your primary home, i.e., purchase money loan).

The debt forgiveness as taxable income is one factor to consider in deciding whether or not to file bankruptcy.

Tax laws are complicated.  This article is not tax or legal advice.  To determine whether or not and how the above tax laws apply to your particular situation, you are urged to seek counsel from an experienced and knowledgeable tax professional.

Moreover, be proactive.  Before going forward with a short sale, bankruptcy, or debt settlement, seek advice from your tax adviser to determine what, if any, tax consequences there may be.

Copyright 2010


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