One ever-increasing trend tax practitioners will be faced with this tax year will be handling cancelation of debt. As more and more taxpayers lose their jobs, a rise in nonpayment on unsecured debt will follow. If you have not dealt with this issue recently, now would be a good time to extend your knowledge by taking a quality CPE course on the subject or do some serious self-study so you can recognize the issues.
What follows are some basics regarding cancelation of debt. However, it is not intended to be more than an overview on the issue.
- What is cancelation of debt? Taxpayers who borrow money in any fashion without providing collateral have unsecured debt. The lender risks nonpayment by the borrower and has little recourse if the borrower fails to pay according to terms of the agreement. If the lender then cancels or forgives this indebtedness, Internal Revenue Code Section 61(a)(12) will generally cause this canceled debt to be recognized as income to the taxpayer.
- How is canceled debt reported to the taxpayer and/or the IRS? Canceled or forgiven debt not treated as a gift or being otherwise excludable in an amount equal to or greater than $600 is reported using Form 1099-C: Cancelation of Debt. This form provides information including the amount of debt canceled or forgiven as well as other information, which relates to the cancelation.
- Is canceled or forgiven debt always taxable? No. There are several exceptions that can mitigate the recognition of canceled or forgiven debt as income. Most commonly, debts that are discharged in Chapter 11 bankruptcy are not considered taxable income. Insolvency, depending on whether the debt is canceled or forgiven, can prevent some, if not all, of the canceled or forgiven debt being taxable. Most indebtedness associated with qualified principal residences of homeowners — under provisions of the Mortgage Debt Relief Act of 2007 — is exempt from taxation. There are many other circumstances that cause non-recognition of income due to canceled or forgiven debt.
- How is the amount reported on Form 1099-C reported to the IRS? If, after careful consideration, it is determined that the amount reported on Form 1099-C represents taxable income to the taxpayer, where it is reported on Form 1040 depends on the type of debt. For example, nonbusiness canceled or forgiven debt would be reported on Line 21 of Form 1040. If the debt is business debt and the taxpayer uses Schedule C or Schedule F to report business income and deductions, the debt would be reported on those Schedules.
- Should a taxpayer attempt to report canceled or forgiven debt on a self-prepared tax return? This is dangerous territory for most taxpayers. First, it may be the first and only time a taxpayer has ever received a Form 1099-C. Unless inclined to learn about the issues, some taxpayers will simply ignore the issue and hope it escapes IRS detection. However, make it a point to add a question to your organizer in bold letters that asks if the taxpayer received a Form 1099-C during the year. If interviewing a taxpayer face-to-face, make sure the question is one of your standard questions. Best of all, you know your clients and should be in a position to know who is likely to be affected by this situation. Do some phone calling or better yet, schedule an in-house seminar and invite clients who are likely to be affected or who you know have been affected. This is a situation that demands the help of a tax professional.
- What are some consequences of improperly reporting information on Form 1099-C? Standard problems arise out of non-reporting canceled or forgiven debt. First, while it may escape initial detection by the IRS, it is likely to be detected under the Document Matching Program. Often this may be many months after the return was filed and the tax on the income was due. Not only will the taxpayer be subject to the additional tax, the IRS will impose significant penalties and interest for the oversight. Depending on the size of the underreported amount, the timing of the discovery, and the additional assessment, these penalties and interest could represent a significant portion of the total assessment.
- Does the IRS provide additional information regarding canceled or forgiven debt? The IRS discusses the issues of canceled or forgiven debt in their Publication 4681: Canceled Debts, Foreclosures, Repossessions and Abandonments. Other help can be found in Publication 525, Taxable and Nontaxable Income, and in the instructions to Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness, and also on the IRS Web site.
Cancelation of debt can raise complex issues, so again, if you are not up-to-date on this subject, it is strongly advisable that tax practitioners attend a live or interactive CPE course before tackling this issue for a client.
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