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Debt cancellation could be taxable

Posted on April 6, 2017

What are the taxable considerations of settling or canceling a debt? According to the IRS, if a lender cancels part or all of a debt, the taxpayer must generally consider the cancelled debt as income.

Surprised? You are not alone. That’s why Teipen Selanders Poynter & Ayres CPAs want to get the word out about debt cancellation and taxes. Even if you weren’t aware of this rule, you can bet your bottom dollar that the IRS will be on top of it.

Here are 7 tips about debt cancellation:

  • ·      Your primary residence may be exempted. If your canceled debt was a loan on your main home, you may be able to exclude the canceled amount from your income. You must have used the loan to buy, build or substantially improve your primary home to qualify and your home to secure the mortgage. 
  • ·      Loan modifications may be excluded. If your lender canceled or reduced part of your mortgage balance through a loan modification or ‘workout,’ you may be able to exclude that amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program (HAMP). This exclusion may also apply to the amount of debt canceled in a foreclosure.
  • ·      Refinanced mortgages follow special rules. Tax exclusion may apply to amounts canceled on a refinanced mortgage. This applies only if you used proceeds from the refinancing to buy, build or substantially improve your primary home and only up to the amount of the old mortgage principal just before refinancing. Amounts used for other purposes do not qualify.
  • ·      Other types of canceled debt such as second homes, rental and business property, credit card debt, or car loans do not qualify for this special exclusion. Be sure to check with your CPA about other rules that may allow those types of canceled debts to be nontaxable.
  • ·      Form 1099-C: If a lender reduced or canceled at least $600 of a debt, you should have received Form 1099-C, Cancellation of Debt, by Feb. 1. This form shows the amount of canceled debt and other information and must be attached to your return.
  • ·      Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness should be filed with your income tax return.
  • ·      Exclusion extended: The law that authorized the exclusion of cancelled debt from income was extended through Dec. 31, 2016. As with all IRS rules and regulations, restrictions apply. Ask you CPA how this law applies to your situation.

·      Need more information? Contact TSPA for helpful general answers to your questions, or go to irs.gov and look for Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. You’ll find a wealth of specific information and FAQs.

Don’t get surprised by the IRS about debt cancellation!

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Make sure you have the right forms and the right information as you prepare your taxes this year. The last thing you want is the IRS to hit you with penalties and interest for not reporting a debt cancellation properly.