For more than a year now, creditors have been modifying the terms of loans and retail installment contracts by waiving fees, reducing interest, and forgiving principal. The primary goal of creditors and servicers has been to keep borrowers in their homes and driving their cars and otherwise keep accounts performing.
After making efforts to help debtors in this tough economy, there is some concern that the IRS rules regarding debt cancellation could undermine that benefit by requiring creditors to send a debtor a 1099-C Form reporting the amount of debt forgiven, which would require a debtor to report that forgiven amount as income on the debtor’s tax return. Because reporting may give rise to potential tax liability, creditors that have helped customers may hesitate to report the debt as forgiven.
Regardless of whether the amount forgiven will be taxable income for the borrower, the creditor needs to report and send a 1099-C Form if a modification involves a forgiveness of principal to keep the account performing. The IRS rules for creditors who cancel debts have not changed :The IRS rules clearly require the creditor to send the 1099-C Form at the time of an identifiable event. A modification to a credit transaction can result in an identifiable event subject to required reporting. For example, if a creditor offers to discount the principal balance of a loan when the loan is paid off early, or agrees to a loan workout that includes a reduction in the principal balance of a loan, the amount of the discount or the amount of principal reduction is canceled debt regardless of whether the borrower is personally liable for the debt. The amount of the canceled debt must be reported by the creditor on the 1099-C Form.
Whether a debtor will need to pay tax on the amount forgiven is not a factor the creditor needs to consider. The debtor will need to figure out whether the forgiven debt is taxable – and there are situations in which the debtor will be able to exclude the amount forgiven from income. Fortunately, in the wake of the financial crisis, Congress and the IRS recognized the benefits of modifications that involve principal reductions on credit accounts, and have ameliorated income tax implications that result from the cancellation by creating exclusions under certain circumstances.
First, Congress recognized the potential consequences of requiring a borrower to pay tax on the amount of debt cancelled after foreclosure or a mortgage loan modification and passed the Mortgage Forgiveness Debt Relief Act of 2007. This Act generally allows taxpayers to exclude as income debt discharged on their principal residence. Debt cancelled through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. The Act applies only to forgiven or cancelled debt used to buy, build, or substantially improve a principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. The Act limits the applicable exclusion for qualified principal residence indebtedness to debt forgiven in calendar years 2007 through 2012. These dates were extended by the Emergency Economic Stabilization Act of 2008, and this exclusion for debtors now applies to debt discharged after 2006 and before 2013.
Second, for non-mortgage debt, the exclusion is not so clear, but, according to IRS issued guidance, cancellation of other types of debts may still be excluded from an income under the insolvency exclusion. Generally, a debtor would not be required to include forgiven debts in income to the extent that the debtor is insolvent. Insolvency occurs when a person’s total liabilities exceed total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. Fewer exclusions apply to business purpose debt discharge, so waiver of principal on a business purpose obligation more often results in income to the business debtor.
Creditors need to be sure that they are fulfilling their obligation to send the 1099-C Form where required under the IRS rules. It will be up to the debtor to figure out if an exclusion is available. Congress and the IRS have ensured the availability of exclusions that a debtor may take advantage of, so that the debtor may receive the benefit of a credit transaction modification without burdensome tax implications that would defeat the purpose of the modification. Because creditors must report debt forgiveness using the 1099-C Form, creditors’ customer service reps are likely get to a barrage of calls from concerned borrowers after receiving the 1099-C Forms. Creditors may want to prepare customer service representatives to suggest that those concerned borrowers visit the IRS web site that explains the exclusions from discharge of indebtedness income treatment (http://www.irs.gov/pub/irs-pdf/p4681.pdf) and/or consult with a tax advisor on the debtor’s options. In the end, creditors should rest easier knowing that keeping a debtor in a home or in a car will result in a benefit to the debtor that will not be undone by reporting the debt forgiveness.
Nicole Frush Munro is a partner in the Maryland office of Hudson Cook, LLP. Basis Points readers can reach Nikki at 410-865-5430 or by e-mail at nmunro@hudco.com.