Itâ€™s January, which means federal income tax season is once again right around the corner. The tax code is long and complicated and covers almost every imaginable scenario, even debt relief. Thatâ€™s right â€” if you received debt relief services such as credit card debt settlement or a mortgage modification in 2010, then youâ€™ll likely be considered to have cancellation of debt income and will probably owe federal income taxes on the portion of forgiven debt.
While that reality isnâ€™t any fun, itâ€™s a lot better than being audited. And although weâ€™re not tax experts, weâ€™ve provided a helpful summary of what you might be looking at in terms of tax responsibilities resulting for debt relief services. Of course, we recommend that you consult a tax professional who can help you prepare your return accurately. After all, you donâ€™t want to make mistakes with the IRS.
Generally speaking, youâ€™ll probably owe federal income taxes on cancelled debts if the cancelled amount exceeds $600. Possible sources of cancellation of debt income include credit card debt settlements, loan discounts or modifications, and home loan modifications.
Nonbusiness Credit Card Debt Relief
You might be able to exclude cancelled nonbusiness credit card debt from federal income if the cancellation occurred in a title 11 bankruptcy case or you were insolvent immediately before the cancellation. Otherwise, youâ€™ll probably have to pay taxes on the forgiven debt.
Loan Discounts and Loan Modifications
For loan discounts and loan modifications, youâ€™ll likely owe income taxes on the amount of the discount or the amount of the principal reduction if are personally liable for the debt (called recourse) and keep any associated collateral. However, if youâ€™re not liable for the debt (called nonrecourse) and you didnâ€™t keep the associated collateral, you donâ€™t have cancellation of debt income and you wonâ€™t have to pay taxes.
Home Mortgage Modifications
Whether you pay taxes and how much you pay on home mortgage modifications is complicated. You might be able to exclude some or all of a principal balance reduction from federal income taxes, especially if the reduction was secured through the U.S. Home Affordable Modification Program (HAMP). For more information, see the sections of IRS Publication 4681 on Qualified Principal Residence Indebtedness, including the subsections under Exclusions and Reduction of Tax Attributes.
Exceptions from cancellation of debt income may include income from cancelled debts as the result of a gift, certain student loan forgiveness programs, certain types of deductible debt, and often when reductions in collateral prices occurred after a sale.
Exclusions from cancellation of debt income are provided in some cases of bankruptcy and in insolvency and in some cases of qualified farm indebtedness.
Remember, this is just a brief rundown of some of the things youâ€™ll need to know about your tax liability resulting from cancelled debts and debt relief services in 2010. You should use this information simply to help get your paperwork in order before consulting a tax professional.
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