Many individuals who fell on hard times may have struggled to pay their mortgage, or they spent hours negotiating their credit card debt with their lender. If these scenarios resulted in a foreclosure or cancelled balances, it's important for borrowers to know how these actions will impact their tax bill so they can be prepared for paying taxes on forgiven debt.
Cancelled Credit Card Debt
The Internal Revenue Service often treats cancelled debt as taxable income. For example, if an individual carried $15,000 in credit card debt, and the lender agreed to forgive $8,000, the borrower may be taxed on that $8,000 because it’s classified as income for tax purposes. This can come as a shock to many Americans who are struggling to get their finances back in order.
In some cases, taxpayers who receive a 1099-C notice regarding cancelled income from credit card debt may be exempt from paying taxes on a portion or the full amount of those funds. By IRS standards, those whose liabilities exceeded their assets when the debt was settled were insolvent, which may mean they don't have to pay forgiven debt.
Foreclosures are another scenario that may result in a tax bill from Uncle Sam. However, this can be considerably more complicated than cancelled credit card debt. Those who lost their homes due to foreclosure should consult their tax preparer to discuss their liability for paying taxes on forgiven debt.
The IRS treats foreclosures as the sale of property, meaning that owners are required to pay not only capital gains on the "sale," but also tax on income from cancelled debt, depending on whether they carried a recourse or non-recourse loan.
Recourse vs. Non-recourse Loans
Consumers who held a recourse loan are personally liable for the debt, and lenders may pursue repayment following the foreclosure. Those with non-recourse loans are not legally liable for their balances. Instead, lenders repossess the property to secure the loan.
To determine capital gains or losses, the basic formula involves subtracting the adjusted cost basis of the property from the purchase price — plus any home improvements — from the fair market value of the property or, for non-recourse loans, the outstanding loan balance immediately prior to the foreclosure. If the calculation resulted in a gain and the borrowers used the home as their primary residence for at least two years during the five-year period ending on the date of foreclosure, they may qualify to exclude up to $250,000 from income. This amount increases to $500,000 for married couples filing jointly.
Lastly, those with non-recourse loans will not have cancelled debt income because lenders may not pursue repayment of the loan. However, those with recourse loans may find that they are liable for their balances and should consult a tax professional following the sale to discuss their particular situations about paying taxes on forgiven debt.
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