If you received a 1099-C reporting forgiven or cancelled debt, you may be grappling with how to minimize the taxes you may have to pay as a result. Some taxpayers will be able to avoid paying taxes on part or all of the amount listed as discharged on the 1099-C if they qualify for an exclusion such as the insolvency or bankruptcy exclusions, or the Mortgage Forgiveness Debt Relief Act exclusion that Congress has extended through the end of 2013. Taxpayers who qualify for exclusions will fill out Form 982 and include it with their tax returns.
But that’s often much easier said than done. I’ve been writing about 1099-Cs for three years now and I still find parts of the instructions for Form 982 nearly incomprehensible. In particular, Part II of Form 982 can be very difficult to navigate. So I enlisted the help of Jo Ann Koontz, CPA and attorney with Koontz and Associates to help explain what it’s all about. (Part I of Form 982 is discussed in this article, 1099-C In the Mail? How to Avoid Taxes on Cancelled Debt.)
She agrees that this form can be confusing; in fact, other CPAs sometimes enlist her help to complete this form for their clients. “They may see one or two of these a year, but I see a few a month,” she explained.
Note: This article is aimed at consumers who are filling these forms out for cancelled consumer debts. It is not aimed at business owners or owners of rental properties. Because those calculations can be much more complicated, I suggest you consult a tax professional with expertise in these forms rather than try to do it yourself. You may also discover, after reading this, that you need professional tax help even if your situation doesn’t involve business debts.
First, Koontz explained the basics for Form 982:
It has been common practice for taxpayers who qualify for exclusion of recognition of cancellation of debt (COD) income to report their COD income on Form 1040 as “other income.” In the space set aside to describe other income, taxpayers generally indicate that the income was due to cancellation of debt, refer to an attachment for an explanation, indicate a taxable amount of “0,” and provide an explanation of why none of the gross amount of COD income was taxable in the referenced attachment.
Despite the fact that this procedure is widely used, without Form 982 it is incomplete. In order to accommodate reporting by taxpayers who qualify for exclusion of COD income, the IRS developed Form 982 and stated that taxpayers who are eligible to exclude cancellation of debt from their taxable incomes “must take the affirmative action of filing Form 982” in order to do so. The IRS also observed that “very few taxpayers file Form 982, and the Office of the Taxpayer Advocate has focused and will continue to focus on increasing public awareness of the rules and exceptions.”
Then we delved into Form 982, which contains two parts. As Koontz explained, Part I answers the question, “Do I pay tax on this COD income?” Part II answers the question, “If I don’t pay tax, do I have to make an adjustment to the basis of an asset?” This second part deals with “reductions in tax attributes.” A tax attribute, she told me, is basically the adjusted basis in another asset.
If you’ve been filing relatively simple tax returns for the past few years then you may have not come across this term. But if you have sold a home or stock, for example, then you will recognize the term “basis” because it helps you figure out how much tax you may have to pay on any gain. As a super simplistic example, suppose you acquired an asset for $2 and then you sold it for $3. In most cases, the IRS will expect you to pay taxes on that $1 gain. If, for some reason, though, you were required to reduce the basis of that asset (that “tax attribute”) by, say, 50 cents, then your gain would be $1.50 and you’d owe more tax.
Essentially, what Part II for Form 982 is aimed at is preventing taxpayers from “double-dipping,” said Koontz. “The IRS says we’ve already given you a break so we’re not going to give you another.”
Koontz explained that a taxpayer filling out this form must go down the list of tax attributes listed in Part II to figure out if any apply. In most cases, none will. But “where this is most likely to hit people is when a qualified principal residence is involved,” she said. If you lost your home in a short sale or foreclosure, for example, but qualify for the exclusion that lets you avoid paying taxes on COD income under the Mortgage Debt Forgiveness Tax Relief Act, you are also required to reduce the basis in the property.
And that, in turn, could affect any capital gains tax you may owe under a different section of the tax code: Section 121. Generally, if you sell a home or other real estate, you must pay taxes on any capital gains. But under Section 121 of the Tax Code, if you sell your home that you have lived in as your principal residence for two out of the past five years you may be able to avoid capital gains taxes on the profit (gain). Single taxpayers can generally exclude $250,000 in gain while certain married taxpayers get to exclude $500,000.
What That Means for You
Let’s look at how that ties into the 1099-C issue. Here’s an illustration:
You bought your home for $400,000 a few years ago and wound up selling it in a short sale for $150,000. So $250,000 in debt was wiped out. You qualify for the exclusion under the Mortgage Forgiveness Debt Relief Act so you don’t have to include the forgiven $250,000 in your taxable income. You claim that exclusion on Form 982.
But when you do, you must also reduce your basis in the property by the amount you excluded in Part II of Form 982. In this case, you reduce the basis by $250,000. That means for tax purposes it looks like you “paid” $150,000 for your home, not $400,000. (Warning, I am using these terms loosely for purposes of this article to make a point but they aren’t officially the correct terms the IRS would use.)
Remember, if the sales price exceeds the gain then the taxpayer may owe taxes on the gain. In this example, so far, there is no gain so this shouldn’t be a problem.
But let’s say, for example, the same year that you sold that home in a short sale you also settled $50,000 in credit card debt for $20,000. So you receive 1099-Cs totaling $30,000 from those credit card companies. So now you must reduce the basis in the home by another $30,000 — to $120,000.
That’s still not a problem in this example, because the “gain” in the sale of the home is only $30,000 which is well below the threshold in Section 121 mentioned above.
Where this can create problems is when taxpayers have very large amounts of cancelled debt, are single (because they only get to exclude $250,000 in capital gains under Section 121) or when they had second mortgages that were cancelled. There may also be a big tax bill awaiting a homeowner who moved out of their principal residence and turned the home into a rental property for more than two of the past five years.
The good news is that most taxpayers dealing with personal debts that qualify for insolvency, bankruptcy or the Mortgage Debt Forgiveness Relief Act exclusion won’t get tripped up by Part II of Form 982.
But some will.
And knowing which group you fall into may require professional tax assistance from someone who really understands this form. “This doesn’t happen to a lot of people,” admits Koontz. “It’s very narrow but it’s very confusing.