Let’s travel back in time, 35 Hundred years ago, and I’ll take you to the fertile Crescent, between the Tigris and Euphrates where King Hammurabi, has written his famous law code, which addresses, among other things, debt forgiveness. Specifically, the 48th provision of the Code of Hammurabi says, “If any one owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not growth for lack of water, in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for this year.” Well, Hammurabi, be damned, because in 1955 the Supreme Court of the United States held, that Congress in enacting income taxation statutes that comprehend "gains or profits and income derived from any source whatever," intended to tax all gain except that which was specifically exempted. In a nutshell, the court ruled that income is not limited to "the gain derived from capital, from labor, or from labor and capital combined." Or in layman’s parlance, debt forgiveness is taxable! And the seminal tax court case for tax law aficionados is Commissioner v. Glenshaw Glass Co.Accordingly, when an overextended homeowner is underwater, she’s left to drown.
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Canceled Debt – Is It Taxable or Not?
A debt includes any indebtedness whether you are personally liable or liable only to the extent of the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, a repossession, a voluntary return of the property to the lender, abandonment of the property, or a principal residence loan modification.
In general, if your debt is canceled, forgiven, or discharged you will receive a Form 1099-C, Cancellation of Debt, and must include the canceled amount in gross income unless you meet an exclusion or exception. If you receive a Form 1099-C but the creditor is continuing to try to collect the debt, the creditor may not have canceled the debt. You should verify with the creditor your specific situation; you might not have cancellation of debt or taxable income.
In general, you must report any taxable amount of a canceled debt for which you are liable as ordinary income from the cancellation of debt, on Form 1040, U.S. Individual Income Tax Return, or Form 1040NRU.S. Nonresident Alien Income Tax Return, and associated schedules, as advised in Publication 4681Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals). You must report the taxable amount of a taxable canceled debt whether or not you receive a Form 1099-C.
Caution:If property secured your debt and the lender takes that property in full or partial satisfaction of your debt, you are treated as having sold that property and may have a taxable gain or loss.The gain or loss on such a deemed sale of your property is an issue separate from whether any cancellation of debt income associated with that same property is includable in gross income. See Publication 544, Sales and Other Dispositions of Assets, and Publication 523, Selling Your Homefor detailed information on reporting gain or loss from repossession, foreclosure or abandonment of property.
Canceled debts that meet the requirements for any of the following exceptions or exclusions are not taxable.
Debt Cancellations or Reductions that Qualify for EXCEPTION to Inclusion in Gross Income:
Amounts specifically excluded from income by law such as gifts, bequests, devises or inheritances
Cancellation of certain qualified student loans
Canceled debt, that if it were paid by a cash basis taxpayer, would be deductible
A qualified purchase price reduction given by a seller
Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program
Canceled Debt that Qualifies for EXCLUSION from Gross Income:
1 Debt canceled in a Title 11 bankruptcy case
2 Debt canceled during insolvency
3 Cancellation of qualified farm indebtedness
4 Cancellation of qualified real property business indebtedness
5 Cancellation of qualified principal residence indebtedness
The exclusion for qualified principal residence indebtedness provides tax relief on canceled debt for many homeowners involved in the mortgage foreclosure crisis currently affecting much of the United States. The exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of canceled qualified principal residence indebtedness.
Generally, if you exclude canceled debt from income under one of the exclusions listed above, you must reduce certain tax attributes (certain credits, losses, basis of assets, etc.), within limits, by the amount excluded. You must file Form 982Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the amount qualifying for exclusion and any corresponding reduction of those tax attributes. For cancellation of qualified principal residence indebtedness that you exclude from income, you must only reduce your basis in your principal residence.
If you received a Form 1099-C and the information is incorrect, contact the lender to make corrections. Refer to Publication 4681Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), for more detailed information regarding taxability of canceled debt, how to report it, and related exceptions and exclusions. Publication 525, Taxable and Nontaxable Income, contains additional information. If you received a Form 1099-A(PDF), Acquisition or Abandonment of Secured Property, review Topic 432for more information.
The importance of filing tax returns
Some people say they work best under pressure and choose to procrastinate on important tasks like filing taxes. Then there are those who simply forget to file by the April 15 deadline – or deliberately avoid doing so.
Everyone makes mistakes, especially when under the stress of gathering documentation, crunching numbers and lowering tax liabilities as much as legally possible. However, avoiding your annual tax returnobligations can result in costly consequences that extend beyond your bank account.
Late penalties
Considering the importance of filing your tax return, it's fair to expect some degree of penalty for failing to file your taxes. If you are expecting an income tax refund, chances are you won't get the same level of scolding from the Internal Revenue Service that others who owe money can expect to receive.
However, if you fall among the people who owe the government money, it's time to shake a leg and get your tax return in as soon as possible.
The penalty for filing late takes effect immediately following the April 15 deadline and will typically equal 5 percent of the unpaid taxes you owe for every month you delay filing your return, up to a 25 percent cap.
A less hefty penalty of 0.5 to 1 percent of your unpaid taxes per month applies to taxpayers who file by the deadline, but owe taxes and don't pay up. Even if you can't afford your taxes now, it's best to at the very least file your tax return on time.
Those who both file late andfail to pay for the taxes they owe are charged a maximum penalty of 5 percent of their unpaid taxes for every month the bill is late.
Delayed reimbursement
With spring vacations around the corner, you'll likely want to keep all the money you can. Those who wait beyond the eleventh hour to file taxes and claim their refunds may not only get dinged with a late-filing penalty, but holding up refunds does an equal disservice.
Ever hear people preach about not giving Uncle Sam an "interest-free loan?" By failing to file your taxes, you're only prolonging this financial injustice against your wallet. Essentially, you’re giving up the ability to save or invest that money at a higher return.
Forfeiture of tax refund
Just because you don't owe the IRS money doesn't mean you can keep your refund on hold indefinitely. When you're owed a reimbursement from the government, its in no rush to pay you back. In fact, Uncle Sam will give you three long years after the tax year for which you filed to claim your back tax refund. After this generous window, however, the IRS will consider your unclaimed refund a generous "donation," and you'll be out of your rightful cash.
4. Substitute for return
Individuals who fail to submit their tax return by the deadline (or extension deadline, if applicable) aren't in the clear yet. In fact, the IRS will attempt to contact delinquent tax filers repeatedly and remind them to file their tax returns.
If their efforts fail, the IRS reserves the right to file a substitute for return on behalf of the filer. The form calculates the amount of taxes owed based on taxable income, plus any applicable penalties. Payments made to self-employed individuals are also used in SRF computations, as are dividends paid on investments.
But a substitute for return isn't necessarily conducted in filers' best interest. This course of action does not take into account tax credits and deductionsthat may reduce your taxable income, which means you may be overpaying on your taxes in the end.
If you receive a bill from the IRS indicating that it performed an SRF, you can still file your tax return to claim your deductions and expenses. The IRS usually will make the appropriate corrections.
How to find out what’s been reported
Before completing your tax return, you might consider obtaining a transcript from the Internal Revenue Service showing all of your wages and income reported to the agency. You never want to omit income reported to the Internal Revenue Service on your tax return. Not only will you receive a letter from the IRS several months later requesting additional taxes to be paid, but you will be charged interest and penalties on the amounts omitted. If you do not know already, the interest and penalties charged by the Internal Revenue Service can be very significant over time, as much as the original tax liability, if not more. Even more importantly, the omission of income on your tax return might prompt an audit of your tax return by the IRS, a prospect never welcomed by any taxpayer.
Sometimes tax preparers will request a transcript on your behalf in order to confirm that all amounts are complete and agree with what has been received by the IRS, especially if your files appear to be missing documents or are in a state of disarray. There is always the possibility that you failed to receive 1099 or W-2 forms—particularly if you have changed your address recently—or more likely that you lost or misplaced them. Consequently, it may be prudent to determine what has been reported to the IRS. If a tax form has been incorrectly submitted, you can then request that the issuer prepare a corrected 1099 or W-2 and submit it to you and the Internal Revenue Service or Social Security Administration, depending on the type of form.
In order for your tax preparer to request your transcripts, you will need to authorize him or her by filling out and signing a Power of Attorney authorization, Form 2848. I customarily fax these forms over to the IRS as soon as possible, since it sometimes takes a considerable time for the IRS to process them. It is advisable to include the past three years on the Power of Attorney (POA) form, in the event of any future need to amend prior years tax returns.
If you request a transcript and desire it to be faxed immediately, you will need to have a separate phone line for your fax machine, since the IRS requires you to be physically present at the fax machine to acknowledge its receipt; otherwise, the IRS will not immediately fax the transcript to you, but will schedule a fax of your transcript sometime within the next 48 hours. Moreover, unless you speak to a live customer service representative, the IRS's automated telephone menu will process your transcript by mail, which may take anywhere from 10 to 30 days to receive. So be certain to speak to a live agent and specifically request an immediate faxing if time is of the essence, which ordinarily it is when it comes to preparing a last minute tax return.
To assist you in preparing your tax return, you should request the Wage and Income Transcript, which includes data from Form W-2, Form 1099 series, Form 1098, and Form 5498 series received by the Internal Revenue Service over the past 10 years.
If you need other information, such as the estimated tax payments that you made, penalties and interest assessed against you or paid by you, interest received from the IRS, adjustments made by the IRS on returns filed, your balance of outstanding tax liabilities, or if extensions or returns were received by the IRS, then you would request an Account Transcript. Account Transcripts are available for most tax returns for the current processing year and the three prior years.
If you lost a copy of your prior year’s tax return and need it in order to prepare this year’s tax return or to meet the requirements for lending institutions for mortgage verification purposes, you can request a Tax Return Transcript. The Tax Return Transcript shows most line items contained on the return as it was originally filed, including any accompanying forms and schedules. However, it does not reflect changes made to the account after a return is processed.
IMPORTANTWhy request a Tax Return Transcript and not a copy of your originally filed tax return from the IRS? Transcripts can be requested over the phone and received by fax, allowing for immediate receipt if necessary. And there is no charge for a transcript. On the other hand, an exact copy of a previously filed and processed tax return and all attachments requires the mailing of Form 4506 along with a payment of $57 for each tax return requested. While Tax Return Transcripts are only available for the current year and previous three years, copies of tax returns are available for seven years after their filing dates.
A new kind of transcript evolving largely in response to considerable amended return fraud reported by lending and credit institutions is the Record of Account Transcript. In essence it is a combination of the tax return and tax account transcripts containing the line items on a tax return transcript plus any adjustments. As noted above, the tax return transcript shows items as originally filed without reflecting any changes afterwards, while the tax account transcript shows those changes without including items as reported on the original return. The Record of Account displays both the originally filed and amended values all on one transcript. Like the Account and Tax Return Transcripts, it is available for the current year and three prior tax years.
Be prepared to wait over an hour before you reach someone on the phone at the IRS to take your transcript request as well as to be interrogated by a drill sergeant, confirming your identity. Besides your name, address, social security number, and date of birth, the IRS will request your filing status of your last submitted tax return and other information; so have last year's tax return on hand.
In addition, if you are filing a joint return and you need a transcript of your spouse's information, he or she will need to speak directly to the IRS agent on the phone to request such information. Because of the tightening of privacy rules, unless your spouse is present with you, the IRS will not fax your spouse's information without his or her direct confirmation of identity on the phone with you.
When the IRS representative questions you on the phone, be sure that only youanswer his or her questions. If the agent hears your spouse in the background providing answers to the questions, your call may be terminated on the grounds that you are impersonating the taxpayer. So muzzle your spouse and be prepared, careful, and vigilant until your request for your individual transcript has been approved and processed by the IRS agent. Then hand the telephone receiver over to your spouse to request his or her own transcript.
If you do not wish to subject yourself to such an interrogation, wait on the phone for over an hour, or use the automated request line to request a transcript, you can process Form 4506-T Request for Transcript of Tax Return and mail it to the IRS office indicated for your location. Although the form’s title specifies a transcript for a tax return, you can request all four different transcripts previously discussed on this tax form. There is no charge for the transcript and you should receive it in 10 business days from the time the Internal Revenue Service receives your request, so allow up to 30 calendar days to receive the transcript.
The Internal Revenue Service has a wealth of information on you in its computerized database. You may request this information by processing transcript requests either by telephone or mail. If you need information to prepare a tax return or make a payment, request a transcript over the phone and request that the information be faxed to you. Be certain to request the appropriate transcript, since there are currently four different kinds, depending upon the information you require. If you are in doubt as to which transcript you need, you might consider requesting all four, since there is no cost and it is always better to be safe than sorry, especially with the IRS.
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