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DEBT RELIEF—A TAX TRAP!!

 
If a taxpayer is successful in obtaining either full or partial debt relief from a creditor, be fully aware that the amount of relief obtained is generally treated as TAXABLE INCOME in the year obtained!

     There are two general exceptions to the “taxable income” requirement.  If a taxpayer is granted debt relief in filing a BANKRUPTCY, then the relief is NOT taxable income to the taxpayer!

     Further, if a taxpayer is INSOLVENT at the time the debt relief is granted, it is also NOT treated as taxable income.  Insolvency is determined by subtracting the taxpayer’s total liabilities (what he owes to creditors) from his total assets (what he owns) on the date the debt was relieved.  If assets exceed liabilities, then the taxpayer is not insolvent and the debt relief must be reported as income for the year in question.  However, if liabilities exceed assets in that calculation, then a taxpayer is, in fact, insolvent and the debt relief is not includable in gross income.

     We further recommend that any taxpayer excluding this type of income from the tax return attach with it both an explanatory note as well as a schedule of assets and liabilities clearly showing that the taxpayer was, in fact, insolvent at the time the debt relief was granted.  This extra step will likely save the taxpayer from having to explain, at some future date, to the IRS why the income was not originally included in income.

     Taxpayers who are trying to exclude this type of income on their tax returns should also keep in mind that the valuation they assign to each of their assets is subjective, at best.  For example, if similar homes in the taxpayer’s neighborhood on a comparable basis are selling in a range of $ 200,000 to $ 250,000, it is certainly within the realm of acceptance for the taxpayer to value that home near the lower end of the range when determining the asset’s value.

     The creditor who provided the debt relief will issue Form 1099-C at year-end--showing the amount of relief granted which is also the amount usually includable in the taxpayer’s income.  Therefore, should the taxpayer simply ignore the form, IRS computers will generate an adjustment notice approximately 12-18 months after the due date of the return in question.

     It’s bad enough to have to pay the amount of taxes we do each year, but this is perhaps just one situation where having the necessary information can possibly save the taxpayer some of those hard earned tax dollars!

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