People think about tax planning as tax savings. And in order to save taxes, you first have to make some money, right? Well, not so fast.
A prime example of that is the wave of people being surprised at finding out they owe thousands, sometimes tens of thousands of dollars on taxes when they walk away from real estate or re-negotiate a credit card debt.
First, here’s the problem. If a lender forgives debt (in the form of writing off a loan or part of a loan), you have what is called debt forgiveness or Cancellation of Debt (COD) income.
COD income is taxable as ordinary income. It gets reported right on the front of your Form 1040, Individual Income Tax return.
Let’s say you have credit card debt totally $50,000 and go to a credit counseling company who is able to get it writtend own for just $10,000 provided you pay it within the next 30 days. It’s a great deal to get this monkey off your back, so you take money out of your 401(k) (what’s left of it anyway), borrow some money from Uncle Jim and even pawn some jewelry. You do what it takes to pay that $10,000.
Whew! That’s done and you can move on. Then you get a Form 1099-C from the credit card company showing that you have COD income of $40,000. You now have tax due on that amount, just as if you’d gotten a paycheck for it. Depending on your tax bracket that could mean as much $8,000 – $15,000 for federal and state taxes.
It’s a similar situation if you have a property you lose in foreclosure. You turn over the keys to the lender and walk away, assuming everything is fine. Then one day, maybe two – three years later, you get a Form 1099-C showing you have forgiveness of debt of $100,000 or even more. The tax on that could be $30,000, $40,000 even $50,000. And the IRS isn’t too happy to wait for their money.
We’re hearing stories every single day of people who suddenly have a tax problem. They are waking up to discover that not being able to pay their debts or having an upside down house they couldn’t afford was the least of their problems. Now they have a tax issue too.
There is a solution – Form 982. There are three exemptions that might work for you on this form. If you qualify, you’ll be able to NOT pay tax.
The three exemptions are for:
- primary residence indebtedness
But it isn’t quite that simple either. You must follow the rules and correctly complete the form, or you’ll lose the exemption. Above all else, though, don’t ignore a Form 1099-C if you get one. You’ve got one chance at getting the exemption. Use it wisely.
Tax planning isn’t just for the good times. You often need tax planning even more if you’ve just gone through a bad time.