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Debt Forgiveness – Tax Implications for You and Your Business 

In today’s turbulent economy taxpayers are forced to re-evaluate their current financial situation which often involves working with creditors to reduce or even eliminate debt. Additionally, the current housing crisis has also posed new challenges for taxpayers and as a result, mortgage modifications are being made, foreclosures are on the rise, and “short sales” are common place. Unfortunately, the potential tax burden resulting from these types of transactions is often overlooked. In an effort to avoid a surprise tax bill, it is important to understand what your potential burden may be and the types of tax relief which may apply to your particular situation. 

What constitutes cancelled debt?
In general, cancellation of indebtedness occurs when a lender agrees to relieve the borrower of repayment of a financial obligation. In essence, the lender “forgives” the amount owed by the borrower. This debt forgiveness may be for an entire obligation or a portion thereof depending on the nature of the transaction.
How will you know if have potential COD income to report?
There are several different types of situations under which a taxpayer may be relieved of all or a portion of a debt by a lender thereby exposed to potential recognition of cancellation of debt (COD) income as a result of such transaction. Most taxpayers are notified of potential income inclusion of forgiven debt through the receipt of a Form 1099-C or Form 1099-A issued by the lender. However, this is not always the case. There are several instances where 1099s are received after a return has been filed or the taxpayer never receives a copy of the form. This is why it is important to identify transactions where debt forgiveness may cause additional tax burden and be aware of your exposure.
What types of transactions give rise to debt forgiveness?
The following outlines transactions which should be examined for potential cancellation of debt (COD) income recognition and/or tax reporting requirements:
·         Loan Modifications/Short-sales/Foreclosures
·         Repossessions of Personal or Business Property
·         Negotiations of Credit Card Debt
·         Student Loan Arrangements
·         Bankruptcy
Under what circumstances may tax on COD be avoided?
Fortunately, there are some exemptions available to provide relief to taxpayers. These exemptions require that proper election is made with the filing of the tax return and may result in reduction of certain tax attributes. The following situations may allow for cancellation of debt income to avoid taxation:
·      Bankruptcy – discharge occurring in a title 11 case
·      Insolvency - exclusion is limited to the extent of insolvency
·      Qualified Farm Indebtedness – available for certain farming activities
·      Qualified Principal Residence Indebtedness – limited to acquisition debt on principal residence
·      Qualified Real Property Business Indebtedness – includes debt incurred or assumed in connection with a trade or business
What should you do if COD applies to you?
Ultimately, debt forgiveness can pose unexpected negative tax consequences which may otherwise be avoided with proper tax planning and guidance from professionals who understand the intricacies of related tax law. It is important to note that the exclusions and deferral opportunities available to taxpayers relating to debt cancellation income recognition have various limitations and require proper documentation in order for a valid election to be made. We strongly recommend that you take the appropriate steps to consult with your tax advisor in order to properly apply these opportunities to your circumstances. For additional information you may contact Erica K Harp, CPA (eharp@hughessnell.com) or Steven M Davis, CPA (stdavis@hughessnell.com) at (239) 939-2233. We are here to assist and consult with you during these troubled times.
To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used for the purpose of avoiding penalties assessed under the Internal Revenue Code.