Cancellation of Debt

With the economic situation dim in the United States, more taxpayers are facing overwhelming debt and bankruptcy. Taxpayers may find their tax returns affected by debt cancellation for 2008 and beyond. Taxpayers need to be aware of the rules for debt cancellation. Failure to comply with IRS regulations may lead to penalties and interest owed to the IRS. 

If a debt is canceled or forgiven, other than as a gift or bequest, the taxpayer generally must include the canceled amount in income for tax purposes. A debt includes any indebtedness for which the debtor is liable or which attaches to property the debtor holds. Examples include losing a home to foreclosure, and defaulting on credit cards and car loans.

Under the Mortgage Forgiveness Debt Relief Act of 2007, a taxpayer may be able to exclude from tax up to $2 million of debt forgiven on a principal residence. The limit is $1 million for a married person filing a separate return. If the mortgage debt is partly or entirely forgiven during 2007, 2008 or 2009 the taxpayer may be able to claim special tax relief by filling out Form 982 and attaching it to the federal tax return for that year.

Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. The debt must have been used to buy, build or substantially improve the principal residence and must have been secured by that residence. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.

Debt forgiven on second homes, rental property, business property, credit cards or car loans does NOT qualify for the new tax-relief provision. In some cases, however, other kinds of tax relief, based on insolvency, for example, may be available. See Form 982 for details.

If the taxpayer’s debt is reduced or eliminated he will receive a year-end statement (Form 1099-C) from his lender. By law, this form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure. The lender must send this to the taxpayer no later than January 31.

The IRS urges borrowers to check the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. The taxpayer should pay particular attention to the amount of debt forgiven (Box 2) and the value listed for the home (Box 7).

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