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SALT LAKE CITY -- Imagine you've been making strides to get out of debt. You've been watching TV commercials for debt consolidation plans and listening to counsel on getting out of debt. One by one, lenders begin to slash your debt, in short forgiving large sums of money -- thousands you won't have to pay back.
It's a relief until you receive a notice from the Internal Revenue Service informing you the thousands of dollars of debt you got rid of is considered "income." Now you're back to square one with a load of debt.
"It seems hardly fair that if you're in a situation where you can't afford to pay your debt ... you have to pay taxes on something you don't get." Allan Zabel
"The IRS likes to tax anything it can get a hold of," said Allan Zabel, a tax attorney/preparer at Zabel Law Office. "Anytime you have a canceled debt of any kind, from a credit card, from the sale of your home, you need to talk to your tax preparer."
Zabel suggests talking to a tax preparer because taxable income such as debt forgiveness is rife with rules and comes with limitations. Zabel said, for example, if you owe $400,000 on a home that goes into foreclosure, the bank sells the home for $300,000 and writes off the rest of what you owe. The IRS considers the $100,000 in forgiven debt as taxable income. However, that figure is also dependent on the fair market value of the house.
"It seems hardly fair that if you're in a situation where you can't afford to pay your debt and at the same time you get some help by someone canceling your debt, you have to pay taxes on something you don't get," Zabel explained.
But he said there is some wisdom to that. For example if you use that money to buy a boat or a car, then you have that piece of property as an asset.
Zabel also said in 2007 Congress tried to limit how much the government can tax people.
"They're limitations designed to help the middle and lower income class of people," explained Zabel, "and not the higher earners who have two million dollar homes and that kind of thing."
The tax rules for debt forgiveness income apply to everyone; however, it depends on the person's tax income bracket.
"They have different impacts depending on where people are at financially," explained Zabel.
Those tax limitations are due to expire in 2012. There is also the option of bankruptcy said Zabel, but that has its own complications.
"If you wait until the lending institution has issued a 1099-C, which is for canceled debt, that's too late. At that point, the canceled debt becomes a taxable transaction," he said.
Still Zabel suggests people counsel with their tax preparers to make sure their taxes are handled properly. One way around this taxable debt forgiveness is if a family member gives you a monetary gift.
"Say you have a loan from your uncle for $10,000. He recognizes your financial plight and says I'm going to cancel your debt," explained Zabel. "That is not taxable cancellation debt if it's done as a gift."
E-mail: niyamba@ksl.com
