Debt settlement has a hidden tax consequences no one ever discusses. If you own a home, debt settlement can bite you in the asset down the road.
That’s because debt forgiven outside of bankruptcy gets deducted from the basis of your home. Result: more potentially taxable capital gains on sale.
That’s the killer reason why bankruptcy alone protects you from a serious tax consequence down the road.
Here’s the backstory and the low down on the exception to the exception that protects your home from a tax hit in the future.
Tax consequences of forgiven debt
When choosing between bankruptcy and settling your debts outside of the bankruptcy court, an advantage to bankruptcy has always been the favorable tax treatment of forgiven debt.
Debt forgiven or cancelled in bankruptcy is not added to taxable income. IRC 108
You may receive a 1099 form showing the forgiven debt, but by filing Form 982, you claim your right to exclude the forgiven debt from your income.
By contrast, make a deal with your creditors to take, say, 1/3 of what you owe in full settlement, and Uncle Sam treats the 2/3 of the debt that was cancelled as if you received it in cash. It’s taxable income, says the IRS. Ouch!
Avoiding immediate taxation
Insolvency is another exception to including cancelled debt in taxable income for the year it’s forgiven. If you are insolvent (your debts exceed your assets), then you don’t have to include cancelled debt in your taxable income. Again, you file Form 982 and demonstrate insolvency.
Just like the bankruptcy exception.
BUT, both methods of avoiding an immediate tax consequence require that you reduce tax attributes like basis by the amount of the forgiven debt.
So, there’s no immediate tax hit, but your basis in your assets (usually, purchase price and cost of improvements less depreciation) shrinks by the amount of debt cancelled.
Why reduction in basis is important
Your basis in your assets becomes critical when you sell.
The biggest asset affected is real estate. (Much to many people’s surprise, the tax code no longer provides for a tax free rollover of gain on a principal residence.) Your capital gain is, roughly, the difference between the sales price and your basis in the house.
After an exclusion of gain if the property is your principal residence, the balance of the gain is taxable.
So the immediate tax relief of not recognizing cancelled debt in income is off set by a sort of recapture on the later sale of appreciated assets.
Special bankruptcy tax rule for homes
But wait! Wait! There’s an exception to the reduction of basis rule that shields your principal residence if claimed exempt in bankruptcy.
Discharge debt in bankruptcy, rather than by settlement with the creditor, and claim an exemption in your property, even if it had no equity when you filed, and your basis in your home is unaffected by the reduction in tax attributes. IRC 1017(c),
So, when you consider your alternatives for getting yourself out of debt, you need to consider the debt settlement tax consequences. Homeowner must look beyond this year’s tax return to the point at which they may sell their house and owe capital gains taxes.
Get professional tax advice if the reduction of tax attributes when cancelled debt income is excluded from income affects you.
More on cancellation of debt issues
Image courtesy of Flickr and Antony Theobald.