Cancellation of debt is an issue that we see increasingly often while preparing tax returns and is something that every taxpayer should understand. Any time there is a short sale, or a foreclosure, or any other such transaction, there is cancellation of debt. These are not the only circumstances in which cancellation of debt occurs, of course, but it’s where we see it most often, especially in the wake of the Great Recession, the effects of which our clients are still experiencing.
There are two basic facts that are most important. First, cancellation of debt is generally considered income to you and is subject to tax at your marginal ordinary income tax rate. That means, for example, if you have a rental property and sell it in a short sale, the difference between the mortgage balance and the amount paid to the bank represents ordinary income to you and will be reported to you and the Internal Revenue Service on form 1099-C: Cancellation of Debt. Second, the debt that was cancelled may be excludable from taxable income to the extent that you are considered “insolvent” immediately prior to the cancellation of the debt. The Internal Revenue Service has provided an Insolvency Worksheet to assist taxpayers in determining whether they are considered insolvent on page 8 of Publication 4681.
Form 1099-C: Cancellation of Debt
There are a couple of questions that you’ll need to ask in order to know how to proceed with your tax professional in the event that you’re married:
- How does filing jointly with a spouse impact the insolvency calculation worksheet?
- If you are married and have filed jointly in the past do you now have to file separately in the year you received cancellation of debt?
To answer the above questions you will need to consider the following factors:
- Is the debt that was cancelled owed by both spouses? If so, both spouses’ assets must be considered for the insolvency test. Jointly owned assets must always be considered in the insolvency test.
- If the debt is not jointly owned, only the assets that are jointly owned and/or separately owned by the debtor are included in the insolvency calculation. For example, if the debt forgiven is on a rental property owned by only one spouse, only that spouse’s solvency is relevant, not both spouses’.
- Married Filing Jointly does not impact the insolvency calculation and any credits that would be disallowed by filing separately may be retained, so there is no need to file a separate tax return in the event that you would otherwise elect to file a joint return.
At GunnChamberlain, we’ve dealt with this issue many times. Understanding the above information is important for taxpayers to have a basic grasp of how cancellation of debt and insolvency work. As always, though, we highly recommend hiring a tax professional in the event that you experience a cancellation of debt. While the overarching concepts of the relevant tax law is relatively straightforward, the details are not.
If you have questions about cancellation of debt and how this may impact your taxes, please do not hesitate to contact us by phone at (904) 296-2024 or by e-mail at email@example.com.