If you have clients who’ve experienced a short sale/foreclosure/deed in lieu – they might be feeling anxiety over impending tax due. While the bad news is that the income from the discharge of indebtedness income is included as taxable income, the IRS gives us a way out. A recent letter of information reminds us that some 1099-C income may not always result in COD income includible in gross income.
Tax liability on the 1099 amount is something to be considered in determining the affordability of a debt settlement. You may want to look at the insolvency clause as a way out. Canceled debt is not taxable to the extent that the taxpayer was insolvent immediately before the cancellation.
Essentially, by adding up the taxpayer’s liabilities and assets you can tell if, and to what extent your client is insolvent. For purposes of calculating total insolvency, you must include the value of everything owned. This includes assets typically beyond the reach of creditors and judgements such as pensions and trusts.
What’s counted as liabilities? For purposes of applying this rule, any recourse debt as well as non-recourse debt up to the FMV of the property used as security for the debt.
A great tool available for this calculation is an insolvency worksheet. We’ve got a FREE insolvency worksheet available here for download:
Report the exclusion on form 982.
If you use this exclusion, you must reduce certain taxable attributes by the amount of the debt excluded. The following are the taxable attributes:
1. Net Operating Loss
2. General Business Credit Carryover
3. Minimum Tax Credit
4. Capital Loss
6. Passive Activity Loss and Credit Carryovers
7. Foreign Tax Credit
The reduction of tax attributes ensures that you don’t “have your cake” and it it too! It is a way of paying back the tax benefits you receive from this exclusion.