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COLUMN from DEAN ALEXANDER: This Installment / Tax Resolution of Mortgage Debt Forgiveness

By Dean Alexander

Many taxpayers are currently (as we speak) subject to an IRS levy, wage garnishment and tax lien as a result of, get this, suffering from an economic hardship. People who are facing a hardship and default on their credit cards, may have a brewing tax problem. This problem starts with a 1099-C, which the credit card company will send the taxpayers. Taxpayers receive this form after they stop paying the credit card debt (which will eventually be traded into a tax debt.)

Basically, 1099-C tells the IRS that we, the credit card company, have forgiven the debt of the taxpayer. IRS in turn, applies the laws on the books, which translate forgiveness of debt into income. If you report the amount forgiven from this form as income, you will have no tax problems or need for any tax help except a new tax debt that you did not anticipate and that you have to pay.

If you ignore that form and you don’t report the cancellation of the debt as an income, you will get, sometime down the road, something called a CP-2000. This form is basically used for underreporting of income. The IRS would specify on this form which income you did not report (in this case forgiveness of the debt) and they would ask you to sign, if you agree. Anyway, whether you sign or not you will end up with back taxes that you have to find a tax resolution for, such as an installment agreement or an offer in compromise.

This conversation used to apply also to mortgage debt forgiveness. If the bank had to write off the loan or the balance thereof after, say, foreclosure, they would send you the infamous 1099-C. You had to include the amount in your income with the ensuing tax problems and the need for the tax relief. This mortgage problem finally received the tax relief that it deserves. Under the Mortgage Forgiveness Debt Relief Act of 2007, the amount forgiven is not taxable up to two million dollars if you are married filing joint and one million if you are married filing separately.

Under this Act according to a new issue of periodic IRS tax tips, this forgiveness also applies to restructuring of your mortgage. This assumes that the forgiven debt or loan was used to pay for the home or substantial improvement which was secured by the residence. So, refinancing for home improvements also qualifies for forgiveness of debt. If, however, some of the proceeds of the loans were used to pay off credit cards, those amounts used for credit card payments will not be forgiven.

Notice that, if you have a rental property, business property, or car loans that are forgiven, they will not be relieved under this act. All of those will be taxable income. You may, if you are insolvent, qualify for the forgiveness of debt under the provision of insolvency. If you are insolvent you may have a way out of this tax debt. If your liability is more than your assets, you may be classified as insolvent.

By way of example, let us assume that everything you own in real estate, cars and stocks, is worth one hundred thousand dollars. If your liability, say, equals two hundred thousand dollars, you are insolvent and you may qualify under the insolvency provision for the forgiveness of debt.  Consult your CPA or an IRS tax attorney to receive the proper advice that fits your case.

In summary, many tax problems causing IRS levy and tax liens and requiring tax resolution such as installment agreement or offer in compromise result from cancellation of debt.