The Law Q&A | Written-off debt may still cost you come tax time

The Law Q&A | Written-off debt may still cost you come tax time

By BRETT KEPLEY

Tax season is upon us.

Did you know that if loan institutions (banks, credit unions, government agencies or other financial lenders) write off your debt with them, the amount that is written off might be income that you must report to the IRS?

Bet you didn't.

There are two types of loans in this crazy world — recourse and non-recourse. Recourse loans hold the borrower liable for the debt. Non-recourse loans do not allow the lender to collect anything other than the collateral (car, house, business inventory, so forth).

Most loans are recourse. If they are, and the creditor gives up trying to collect from you, then good for you.

Unless it's bad for you.

A written-off (discharged) recourse loan under IRS rules will be a taxable event for the amount written off unless the debt falls into an exception or an exclusion. The lender that discharges the debt will send a notice to the taxpayer announcing the amount written off the previous tax year (a 1099-C form).

Some discharged debt exceptions include gifts and bequests; deductible debt (i.e. home mortgage interest — though you can kiss that deduction goodbye under new tax legislation from Capitol Hill); or certain student loans.

Exclusions include debts discharged in bankruptcy; insolvency of the taxpayer (i.e., all debts of yours exceed the value of all property of yours right before the write-off); qualified farm debt; and qualified business real estate and qualified principal residential real estate.

Thus, if your mortgage lender writes off part of your mortgage debt for the house you live in which is qualified principal real estate, that is not taxable (but only up to $2 million — or $1 million if married and filing separately; so if you owe $4 million for a house loan and it is all written off, you will have a $1 million or $2 million income to report — unless you are insolvent).

Joy.

Aside from income tax, the repossession of your property for resale by the creditor might subject you to a tax. The taxable amount is the smaller of the debt written off after sale of the repossessed property or the fair market value of the transferred property.

Suppose you bought inventory for your business for the amount of $20,000, which your bank has a lien on. Suppose you owe the bank $50,000 on all your business loans and go into default. The bank seizes the inventory under their lien rights and resells it all for $20,000 to reduce your debt. They write off the remaining $30,000. The resale of $20,000 is taxable income.

Unless you're insolvent.

Double joy.

Have we taxed your brain yet on taxes for debt write-off? Read IRS Publication 4681 for the details of debt write-off. It's almost as complicated as the NFL catch rule. But 4681 does make for excellent bedside reading.

If you can't pay all your creditors or the IRS, there's always bankruptcy relief, which not only avoids taxes on those debts already written off, but can dump the debt of your remaining creditors.

Just ask the 45th president of the United States about that.

Brett Kepley is a lawyer with Land of Lincoln Legal Assistance Foundation. You can send your questions to The Law Q&A, 302 N. First St., Champaign, IL 61820. Questions may be edited for space.

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