It’s Fix the Tax Code Friday!
This week, I’ve been fielding a number of questions about forms 1099-C (debt cancellation). Under the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA), qualified taxpayers receive an exclusion of up to $2 million (or $1 million MFS) of debt forgiveness on a principal residence if a home has gone to foreclosure or forced mortgage restructuring. Ordinarily, the cancellation of debt for mortgages or other obligations is taxed as income to the extent there is a “gain.”
There have been calls to extend this kind of relief to all personal debts, including credit card debt cancellation, defaults on student loans, and foreclosures on business properties and vacation homes (both fail to qualify under the MFDRA). So, today’s Fix the Tax Code Friday is:
Should the government extend a temporary exclusion from income for the cancellation of personal and/or business debts?
Nah. For a couple reasons: one is that banks get to write down the debt, reducing their taxes, so 1) it’s not symmetric, and 2) it makes it theoretically possible to pay someone without their getting taxed, by lending them money and forgiving the loan. If people are willing to smuggle diamonds to Switzerland in a toothpaste tube, they’re probably willing to play games with debt, too.
Also, one role taxes play is to cushion things — positively and negatively. The impact of a raise is lessened by paying higher taxes, so people are a little less likely to get exuberant; the sting of a paycut can be lessened by the fact that the extra pay from working a little harder (overtime, bonuses) is taxed at a lower rate. This should hold true for debt forgiveness, too: if your net worth suddenly rises because you don’t owe money, you should be taxed the same way that you would be if your net worth rose because you made some more money.
Nope, and the existing act should be repealed. COD should be taxable income unless in bankruptcy, period. I would like to see the gov’t start using long term repayments in these cases though – provide some relief now, but make sure it HAS to be paid back. Perhaps then the responsible folks would be less bitter about bailing out the irresponsible.
Why not allow a deduction against the forgiveness of debt income for the capital loss these people are suffering on the underlying asset? That would seem to “even out” things. These people are definitely not coming out ahead on the whole deal. I had a situation this tax season where a couple bought a house for $660k, had to move to a different city 4 months later, the house was for sale for 3 years before they ran out of money to pay 2 mortgages and ended up in foreclosure. The mortgage balance was $440, and the “FMV” at the foreclosure sale was $220k. They are out their $220k down payment, suffered a $440k non-deductible capital loss, and would have been liable for taxes on another $220k of ordinary income. That doesn’t seem anywhere close to fair to me.
Bert, I would disagree. Paying tax on the COD income is coming out way ahead of earning the funds, paying the tax on that income and then repaying the debt after tax. Pennies on the dollar in fact. What’s unfair is the rest of us picking up the tax bill for these breaks.
I don’t know about the loopholes for businesses, etc, but I know from personal experience this tax on forgiveness of debt can be a nightmare. My aunt died with no will and I was appointed by the court to settle her estate (as next of kin). She had over $80,000 dollars of consumer debt and very little money or assets to cover any of that. I worked very hard with creditors to get the debt load down and share the money with everyone (I could have just had her go into bankruptcy, and at this point that is probably what some of you might recommend). I was just trying to do my best because she couldn’t pay everyone. Surprise, surprise after I paid out to everyone (and set aside the estate taxes), that we had a big tax to pay the following year on the “income” of debt reduction. The whole point was that there was not enough money to pay the entire debt, so where would we get the money to pay the tax? And, yes, we did have an estate lawyer working with us. Unfortunately there were some mistakes made, some deadlines missed by his office, and some poor advice/judgment calls on how to handle a few things. Most notably, his recommendation to take the remainder of the estate and split it between the 4 heirs and have the heirs pay the tax on their own tax instead of the estate paying the tax (because the individuals would be in lower tax brackets). That seemed to make sense, so we did that. But it meant we all agreed to take on any final obligations of the estate too (which we reckoned had been all paid).
In the end, the 4 heirs who each received a payout of $2000 ended up having to claim the income of their aunt’s forgiven debt (over $10,000 each person) on their own income taxes, which significantly affected things like scholarships, EIC, etc. (because the AGI was so much higher, really artificially inflated by the forgiveness income).