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Debt Cancellation: Don't Fall Into an Unknown Taxable Trap

In my years as an Atlanta Tax Attorney and Certified Public Accountant, I have seen many changes (good and bad) to tax law. In my commitment to educate my clients nationwide and in the greater Atlanta area, I wanted to share the latest about cancelled or "forgiven" debt and what it means for taxpayers.

As more families are forced to refinance their mortgages, lose their home to foreclosure or find other ways to cancel mounting debt, the one thing they may not be aware of is the potential tax consequences of their decisions.

Did you know when a lender forgives a debt the cancelled or "forgiven" debt may become part of your taxable income?This could be a very unpleasant surprise come tax time!

Generally speaking cancelled debt refers to any money you have borrowed from a lender that you do not have to repay because the lender "forgave" the amount owed. For example, if you owe $500,000 on your mortgage and the house is sold in a short-sale for $400,000 and the bank forgives the remaining $100,000 owed on the loan, that $100,000 is cancelled debt.

Lenders are required to file a 1099-C Cancellation of Debt form whenever they forgive a debt greater than $600. This form is filed with the IRS and a copy is sent to the borrower. The form will show the amount of cancelled debt as well as any interest forgiven on the debt. In some instances, interest from cancelled debt may not have to be included as taxable income. Later, if you choose to repay a portion of a cancelled debt you have paid the taxes on, you may be able to file a claim for a refund of taxes you paid on the debt.

Some items of particular interest are that not all cancelled debts are the same. It is important to know the differences and what exclusions and exceptions to the cancelled debt/income rules are.

First, those who have debt discharged in a bankruptcy are not required to claim the cancelled debt as taxable income. Also, those who meet the IRS' definition of insolvency do not have to pay income taxes on forgiven debt. Insolvency occurs when the total value of your assets (bank accounts, real estate, stocks and bonds) is less than the total amount of your liabilities (debt owed, financial obligations).

Another exception is if a student loan that contains a provision allowing for some or the entire loan to be cancelled in exchange for the student accepting certain types of employment, then the amount of cancelled debt may not be taxable. Certain types of forgiven farm debt are excluded from being taxed and non-recourse loans that only permit lenders to repossess the property the loan was used to purchase, rather than being able to seize the borrower's personal assets.

Finally, in 2007 Congress passed the Mortgage Forgiveness Debt Relief Act to help protect homeowners who are already experiencing financial difficulties from harsh tax consequences. This Act is currently valid through 2012. The federal law is applicable to cancelled debt from foreclosures and mortgage refinancing in connection only with the homeowner's primary residence and only up to the old mortgage principal balance immediately prior to the refinance. The maximum amount of debt that is allowed to be exempt is $2 Million. If couples choose to file separately the maximum is reduced to $1 Million. This Act does not apply to second homes, business properties or rental properties or other debt such as credit cards or car loans.

Finally, remember, just because a cancelled debt is excluded from your taxable income it does not mean you do not have to report the cancelled debt to the IRS or the excluded income could have other tax consequences. It is always best to consult with an experienced and knowledgeable tax attorney or CPA for more information on this issue.

I am an experienced Atlanta tax attorney and Certified public accountant and I have been helping clients throughout Georgia and nationwide since 1982. When it comes to legal representation of your rights you want experience! The Gartzman Law Firm, P.C. is an Atlanta-based law firm qualified to help you resolve tax problems with practical solutions throughout Georgia and nationwide.

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