When debt is income

guest commentary by David Potts

Many people have suffered financially in our recent economic recession. The City Wire reported this past Thursday that Fort Smith’s 2009 foreclosure rate was up 23.1% over 2008.

Some small businesses have seen their sales drop severely, greatly reducing their income. Others have lost their jobs. Whatever the reason, a lot of people recently found they had debt they couldn’t pay back. As a result they lost their home, a car or had to make a deal with their credit card companies to restructure their debt. I wonder how many considered the tax consequences. I wonder how many considered they might have income as a result of their hard times.

By now you should be receiving envelopes in the mail marked “Important Tax Documents.” If you received a 1099-C Cancellation of Debt, you may have income to report on your tax return that you didn’t expect. If a debt that you are liable for is canceled or forgiven you generally must include the canceled amount in your income.

If you worked a deal with the credit card company and they reduced the amount of debt you owe them, then you may have additional income to report on your tax return. Did you lose your house in a foreclosure? You may have additional income to report. In the case of a foreclosure, the amount of the canceled debt is generally the difference between the amount of the debt owed and the fair market value of the real property on the date the debt was canceled. This information will be reported to you and the IRS by the creditor on Form 1099-C.

Before you get too excited, note that I have been saying “you may” have additional income. There are some exceptions. Debt canceled in a title 11 bankruptcy case is not included in your income. To the extent you were insolvent before the debt was canceled or forgiven, there is no income to report. Certain farm indebtedness is excluded. Also you can exclude qualified principal residence indebtedness.

I don’t have time or space to discuss all aspects of debt cancellation. This is the Internal Revenue Code we are talking about. So I’ll limit our discussion to qualified principal residence debt and how to determine if you were insolvent before your debt was forgiven or canceled. If you do receive a 1099-C in the mail, just because you are unemployed and have time on your hands doesn’t mean you should do your own tax return this year. Seek professional help or get assistance from the IRS.

Qualified principal residence indebtedness is any debt incurred in acquiring, constructing or substantially improving your principal residence, and which is secured by your principal residence. If you refinanced your mortgage or acquired a second mortgage to tap in your home equity to add-on or improve your principal residence, you still have qualified principal residence indebtedness. But if you used the additional funds to pay off your credit cards or to buy a bass boat, that portion of the debt is not qualified principal residence indebtedness and may be taxable income to you. But before you add this portion of your canceled debt to your income, consider the exclusion due to insolvency.

You are insolvent when you owe more than you own. On the day right before your debt was canceled or forgiven, list all the assets you own at their fair market value then subtract everything that you owe. If the number is negative, you are insolvent. It’s simple math. What’s not so simple is finding the fair market value of your assets. Do a little research and be reasonable.

Admittedly this discussion on cancelation of debt is gratefully oversimplified. The sole purpose of this discussion is to inform you that if you have debt that has been canceled or forgiven, there are tax consequences and you generally should seek help in determining the correct impact on your income tax returns.

For a short illustration on how this can get complicated fast, consider the case of a independent truck driver I know. He decided to quit driving his truck for a living, found a job and tried to sell his truck. Apparently trucks aren’t in high demand right now. He couldn’t make his payments so they repossessed his truck. For illustration purposes let’s say the truck’s fair market value was $75,000 and he still owed $100,000. Let’s also assume the truck’s depreciated basis was $40,000. The income from cancelation of debt is $25,000, the amount of the debt less the fair market value of the truck. However, the IRS will also treat the transfer of the truck as if he sold it back to the creditor at the truck’s fair market value. The fair market value less the truck’s depreciated basis would result in a $35,000 gain “on sale” of the truck. If he was insolvent before the cancelation of debt, he would qualify for the exclusion from income on the $25,000 cancelation or forgiveness of debt. However, he’s stuck with the $35,000 gain on the sale of the truck. In reality, for those with cancelation or forgiveness of debt, life isn’t simple.

For more information on debt cancelation go to the IRS Web site and download Publication 4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments — or talk with your CPA.

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

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