Posts tagged as:

debt forgiveness

Ask the taxgirl: Cancellation of “Debt”

May 31, 2009 · 7 comments

Taxpayer asks:

Two years ago, I gave my son a considerable amount of money so that he could finish graduate school without having to take out any student loans. Last year, he announced that he was “taking a break” from school. Since he was no longer going to school, I asked him to give the money back. His girlfriend said that they had already used the money to plan their dream wedding.

I am very angry with my son but I do not want to sue him. It is a lot of money at stake. It is my understanding that I can claim this loss on my taxes by issuing him a 1099. How do I do this?

Taxgirl says:

First of all, my sympathies that things didn’t turn out as you planned. I’m not sure, however, that I’m going to be able to make you feel better.

It appears that what you want to do is treat this as a bad debt. I’m not sure that you can do this since I believe it was a gift. A gift gone bad, perhaps, but a gift nonetheless.

In order for a transaction to be considered a bad debt, you have to be able to prove that it was an actual loan. Under the circumstances as you presented them, I don’t think you ever intended for it to be a loan. I think you gave your son some money as a gift (you even wrote “I gave” and not “I loaned”) and he didn’t use it the way that you intended; my guess is that had your son finished school, you would have never asked for the money back.

That is significant because to claim a bad debt on your taxes, you would have to have proof of a loan (which I’m guessing would be difficult) as well as proof that you’ve made reasonable efforts to collect the debt. It’s worth noting that when it comes to transactions between related parties, the level of proof is generally a bit heightened – the IRS tends to believe that undocumented loans between related parties are really gifts.

Let’s say that you can prove that it’s a loan – you have a promissory note or some other evidence. There are still restrictions on the deductibility. If you’re not in the business of making loans for a living, you have what is referred to as “nonbusiness bad debt.” In that case, the debt must be totally worthless to be deductible. If it is, you report it as a short–term capital loss on your form 1040 at Schedule D; note that it is subject to the capital loss limitations.

When you claim the bad debt, you’ll have to attach a statement to your form 1040 that explains:

  • A description of the debt, including the amount and the date it became due (if you have a promissory note, that would be best);
  • The name of the debtor – you must include an explanation of any familial relationship (in this case, he’s your son);
  • Details of the efforts you made to collect the debt; and
  • What event caused you to decide that the debt was worthless.

Finally, the 1099. You’re thinking about the form 1099-C that we’ve been hearing a lot about in the news. It’s a form of “discharge of debt.” The intention of the form is to provide relief for financial institutions for debts larger than $600. It is not intended for individuals to use to settle nonbusiness bad debts.

The form is evidence for the recipient (the debtor – in this case, your son) of the amount to report on his or her personal income tax return. It is provided to the IRS because cancellation of debt is a taxable event. It’s worth noting that irrespective of issuing the form 1099, your son would be required to report the amount of the debt forgiveness on his personal tax return.

I would advise you to discuss this matter with your son. If it’s a bona fide loan, then perhaps you should give him another opportunity to repay the loan by explaining to him exactly what his obligations are. If he’s old enough to get married, he’s old enough to act like a grown up. A grown up wouldn’t act this way towards Bank of America or PNC.

If it is actually a gift gone bad, I would explain to your son how disappointed you are that he has chosen to ignore your wishes. Perhaps, after the fact, he would be willing to work out a payment plan with you to return the money – even if it is a gift. I would think it would be important to him to start out this next chapter of his life with the support and respect of those around him – especially from what seems like a pretty good father who was trying to pay for his education. ;)

All of that said, good luck. I hope it works out for all of you.

Like any good lawyer, I need to add a disclaimer: Unfortunately, it is impossible to give comprehensive tax advice over the internet, no matter how well researched or written. Before relying on any information given on this site, contact a tax professional to discuss your particular situation.

Have a question? Ask the taxgirl! – Now on Facebook!

{ 7 comments }

Foreclosures, Debt Forgiveness and Mortgage Losses Explained

October 11, 2008 · 8 comments

There’s a lot of good discussion on the Fix the Tax Code Friday comments thread about debt cancellation and mortgage debt cancellation relief. I started to reply to one of the comments and thought it was best to make it a separate post so that it doesn’t get buried.

I wanted to clarify some misconceptions about debt cancellation and mortgage debt cancellation due to a foreclosure. Every instance of debt cancellation – even for mortgages – is not the result of a foreclosure. Mortgages are very fact and circumstance specific since they are negotiated according to state law, an individual’s income and other considerations.

The new (temporary) law regarding mortgage debt forgiveness excludes the cancellation from income in most cases; eligible debt includes mortgage balances on principal residences which totaled less than $2 million. It’s also worth noting that the extension of the new law for mortgage debt forgiveness through 2012 does not apply to home equity loans.

However, this doesn’t mean that the prior law included the entire debt burden as income in every instance. The old law (still on the books and will kick back in after the reprieve in 2012) worked as follows:

A foreclosure is, for tax purposes, like a sale. The bank does not simply take back your house and then report the entire amount of your mortgage as income. There are two parts to calculating taxable income, one to determine the cancellation of indebtedness income, and one to determine any taxable gain.

The first part, to calculate income associated with the forgiveness of indebtedness value, is as follows:
1, Calculate the total amount of indebtedness prior to foreclosure.
2, Calculate the total fair market value (FMV) of the home.
3, Deduct line 2 from line 1.

If the indebtedness is less than or equal to the FMV of the home, there is no resulting income to report. As an example, if I owed $375,000 on a $400,000 home, there is no taxable income to me. If I owed $400,000 on a $400,000 home, there is likewise no taxable income to me.

Income is realized when a borrower has taken out more than the home is worth but only to the extent that the debt exceeds the FMV of the home. This usually happens when: (a) borrower overpaid for the home; (b) housing market drops (often corresponding with a, above); or (c) borrower has borrowed/refinanced for more than the home was worth (often with two or more mortgages).

The reason that there is reportable income when a borrower takes out more than the home is worth is because the bank loses the difference. If I have borrowed against my home for $500,000 but the bank can only recover $400,000, there is a loss to the bank. The bank does get to claim the loss as a deduction. And since the Tax Code is premised on the idea that income should be matched with deductions, there is corresponding income to the borrower equal, more or less, to the bank’s loss ($100,000 in my example).

The second part, to figure capital gain or loss on a foreclosure, is as follows:
4, Take the smaller of 1 or 2 above.
5, Figure your adjusted basis for the property (cost + improvements)
6, Your gain or loss is the difference after subtracting item 5 from item 4.

Treat any gain from a foreclosure just as if you had sold the home. So, if you owned and used the home as your principal residence for at least two of the last five years prior to the foreclosure, you can exclude gain of up to $250,000 (or $500,000 for married couples filing jointly). Any gain over the exclusion amount would be treated as capital gain. And just like with any sale of a primary residence, a loss on a foreclosure is not deductible on an individual tax return. In other words, you wouldn’t pay tax unless you had a significant gain at the foreclosure.

And we’re not done yet! There are two important exceptions to the above: If your debt is discharged through bankruptcy, there is no taxable income to report. And, if you are declared financially insolvent, meaning that your debts exceed the FMV of your assets, you may exclude some or all of the forgiven debt from income.

Make sense? I think that there was an impression that homeowners got slammed twice under the old law in every circumstance. I realize it’s somewhat complicated but the bottom line was that under the old law, so long as you borrowed less than or equal to your current asset values, you did not fall into the debt forgiveness/reportable income “trap.”

The new law has been regarded as rewarding those people who over-borrowed. The existing law did not affect folks who owed less than or equal to the value of their homes – just those who owed more than the value of the home.

Of course, this is a quick and dirty explanation of the prior law. Be aware that each situation is fact specific. For more on cancellation of debt income, you can check out the IRS publication 544 or, of course, consult with your tax professional.

{ 8 comments }