November, 2009 Tax Newsletter

Getting Out of Debt Could Cost You

In this ever-challenging economy we all know people who are trying to get out from under their financial woes.  Even if they are successful, there very well can be a big cost – additional taxes.

Many home owners may have been forced to allow their homes to go into foreclosure.  Due to recent legislation, if the home is a debtor’s principal residence there will at least be no tax consequences (through 2012) to the debtor if the mortgage debt was used to acquire, construct, or substantially improve the residence.  But, as is the case with many debtors, the home was either a second home or a rental property, which resulted in cancellation of debt income under federal tax law.  If the debtor is insolvent or in a bankruptcy proceeding, the income would not be immediately recognized.  Instead the debtor would be required to reduce various future tax benefits he possesses, such as depreciation.  This has the effect of postponing, rather than forgiving, tax on the cancelled debt.

The above situation assumes that the debt on the home was “recourse”, rather than “nonrecourse”, debt.   In recourse debt the debtor is personally liable for the full amount of the debt.  "Nonrecourse” debt is only secured by the property, and the debtor is not personally liable for the balance. 

To illustrate the difference in tax consequences, assume the property was purchased for $100,000 and, at the time of foreclosure, had a value of $160,000 and a recourse debt balance of $180,000.   The debt is deemed satisfied only up to the value of the property.  In this case the $20,000 difference between the recourse debt and the property’s value would be ordinary income from cancellation of debt since the debtor was personally liable for that “forgiven” $20,000.  There would also be a deemed sale of the property at its $160,000 value, resulting in a $60,000 capital gain ($160,000 less the $100,000 cost).  The gain would be long-term if the property was held over one year.  Moreover, if the home was the debtor’s principal residence, the gain may qualify for the $250,000 exclusion ($500,000, if jointly owned).

Now assume the same facts except that the debt was nonrecourse.  In this case, since there is no personal liability to the debtor, the property is treated as being sold for the balance of the debt.  Therefore, the $80,000 difference between the $100,000 purchase price and the $180,000 debt would be long-term capital gain if the property were held for more than one year.  Again, if the home was the debtor’s principal residence it may qualify for the exclusion.  Most debt incurred to acquire residences is nonrecourse debt.

People with large credit card debt are sometimes able to negotiate the debt down.  The difference between the amount paid and the total debt owed is taxable cancellation of debt income..

In the situations involving either cancellation of recourse debt or credit card debt the lender at year end will send Form 1099-C to the debtor reporting the cancellation income.  If the debtor is in bankruptcy or is insolvent he will need to attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to his tax return in order to avoid reporting the income on his return.

Issues regarding debt relief are complex and a qualified tax professional should be consulted.