It’s tax season, and the mailboxes are overflowing with IRS form 1099s.
You probably received a 1099 if you completed a short sale, experienced a foreclosure, declared bankruptcy, or resolved your debt for less than you owed.
But the tax narrative does not end there.
The receipt of the form does not imply that the stated amount must be included in your income.
Repeat after me:
Simply receiving the paperwork does not imply that you will be paying taxes on the money.
Form 1099 is a statement of information. It is commonly sent out without much thinking on the part of the creditor.
When real estate is transferred or debt is forgiven, the creditor is obligated to record the transaction to the IRS. A copy is given to you, the possibly impacted taxpayer.
Here’s how you can avoid paying higher taxes.
Make a case for the exceptions to the rule.
The Internal Revenue Code begins with the premise that forgiven debts improve your net worth. There must be a tax payable, according to IRS logic.
However, there are several exceptions. There are three major exceptions:
- Mortgage debt that qualifies
If you qualify for one of these exclusions, the forgiven debt will not be added to your taxable income.
You must complete IRS Form 982 to substantiate your entitlement to exclude the money stated on the 1099.
If you don’t complete the form and claim the exception, the IRS will have no means of knowing that there is no tax due despite the debt forgiveness.
Tax-avoidance options on Form 982.
The IRS Form 9 82 explains why forgiven debt may not be taxed.
- Bankruptcy– In bankruptcy, the debt is forgiven without any tax penalties. On Form 982, it’s the first exemption. Title 11 of the United States Code contains bankruptcy laws. The tax exemption applies to debt discharges in any bankruptcy chapter.
- Insolvency– You may have owed more to other creditors than the worth of your assets once the loan was forgiven. The forgiven debt does not have to be included in your income. You were bankrupt. However, the value of retirement assets that your creditors can’t obtain is included in the solvency calculation. When you include pensions, etc., many people who have little net worth outside of retirement funds are actually solvent.
With the Great Recession and a rash of foreclosures, Congress provided a temporary safe harbor for debt forgiven on a primary property. The loan has to be utilized to purchase or upgrade the house. The legislation was recently extended to cover the 2016 tax year.
In The Event Of An Error.
Another circumstance in which you can receive a 1099 but not owe tax is if you had no personal culpability for the obligation forgiven; that is, the debt forgiven was a nonrecourse debt. The foreclosure agent is unlikely to know whether the lender has the legal authority to suit you.
When your debt was not truly discharged.
If none of the other exceptions to include income apply, think about whether you were personally liable for the debt. If not, request that the 1099 be amended, or attach a statement to your tax return explaining your position.