While counter-intuitive, forgiven debts are income to the IRS

It’s 2 a.m. and you’re up again! You’ve been worrying about your bills and see no way to get them all paid. Suddenly, you see an infomercial on television which you think will change your life. It’s an advertisement for a debt reduction company which promises to help you get out from under all of those burdensome and oppressive bills.

As with most things in life, IRS tax attorneys warn that if it sounds too good to be true, it probably is; not because the debt reduction company won’t do what they say, but rather because if they do what they say you may end-up finding yourself owing back taxes to Uncle Sam. That’s because the IRS considers forgiven debts taxable income.

That’s right, tax lawyers point out that while debt reduction companies can, and often do, negotiate down what you owe your creditors, every penny a creditor writes off your account will likely be considered taxable income by the IRS. According to Allan Zabel, a tax attorney in Utah, “the IRS likes to tax anything it can get a hold of.” According to Zabel, and other tax attorneys, with millions of Americans defaulting on home mortgages the problem is significant.

Tax attorney Zabel explains that “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.” Zabel is quick to point out however, “there is some wisdom to that. For example if you use the money to buy a boat or a car, then you have that piece of property as an asset.” But, as a practical matter, if you can’t afford to make your house payment and you lose your home through foreclosure, it’s not like you have $100,000 in your pocket to go out and buy a boat. Chances are you are just grateful to get out from under the mortgage payments so you can manage your other expenses.

Although in 2007 the U.S. Congress sought to limit the amount of taxes you might ultimately be subject to paying for forgiven debts; those limitations are due to expire in 2012 and the focus was intended to try to help the lower and middle class income earners, not the rich. Accordingly, tax attorneys say how a forgiven debt impacts your tax liability will depend on your income bracket.

While tax lawyers like Zabel say there are ways to minimize your tax liability through the use of gifts, rather than forgiven debts, everyone’s situation is different and getting answers to your questions is critical to helping ensure you don’t get hit with a huge bill for back taxes. In the end, getting the right answers from a competent tax attorney or other tax professional can help you manage your tax liabilities and stay out of trouble with the IRS.

 

Segal, Cohen & Landis
9100 Wilshire Blvd. Ste. 601E
Beverly Hills, CA 90212
(310) 285-3999

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