The federal tax code taxes debt forgiveness. The tax code also requires those forgiving debts to file information returns to the IRS, using form 1099-C. So, you lose your house in a foreclosure sale and the bank sends a 1099-C for the loss they take on the house. Many taxpayers and tax preparers simply include the debt forgiveness in the taxpayers return as income. However, there are many exceptions to taxation. Some of the most common are:
- Gifts, bequests, devises and inheritances that forgive debts;
- Qualified Student Loan forgiveness plans;
- Cash basis taxpayers with debt that would qualify as a business deduction;
- Price reductions after a purchase;
- Required business debts;
- Bankruptcy discharged debts;
- Forgiveness when insolvent.
If you don’t file your return timely, the IRS may file a substitute for return for you. When the IRS prepares a return they won’t know if an exception applies. The IRS will tax you on the full amount reported. To address the matter you need to file a corrected return where the IRS substitute was filed.
If you don’t report the income on your return it will probably be audited. The IRS auditors have been adding huge tax bills to peoples return on this issue. You use form 982 to claim your exemption from tax for debt forgiveness. The IRS auditor may reject the claim of exemption. To get relief from the bill you may have to file an appeal. The time for filing an appeal to Tax Court is very short. The advantage of tax court is that you don’t have to pay the tax to sue for a refund. If your return was prepared without considering your exemptions we could assist in amending your returns. For help in addressing amended returns, tax audits and appeals, give us a call.