If you have incoming money then you have income. If you have income, the IRS wants to tax it. Simple as that. You may think your salary is all that gets taxed but if you take a close look you’ll find that the IRS has a multitude of ways to tax income that you didn’t even you had. Take cancelled debt, for instance. When you have credit card debt and you can’t pay your bills, sometimes you can negotiate with credit card companies and get your debt cancelled. Well, the IRS views that cancelled debt as income. It’s something you used to owe, and there’s a term for that: a liability. Well, when you cancel you debt you’re cancelling a liability. A removal of a liability is income, according to the IRS. So now you owe income tax to the IRS.
IRS Form 982: Paying Taxes on Cancelled Debt
So when does it happen that you don’t have to pay a debt? What is this debt cancellation they speak of? Sometimes it’s a credit card settlement you reach with the credit card company. You have such a large bill and you’re so delinquent that a settlement is reached: you agree to pay some of it, and they agree to let the rest of it go. That’s cancellation of debt. The credit card company figures it’s better to get some of that money back rather than none of it. And it’s definitely a good deal for the credit card holder in the sense that they get out of paying some bills. Who knows what terrible things it brings for the future, however, such as non ability to ever get credit again. Makes buying a home pretty difficult and expensive.
But anyway, the credit card company will issue a 1099-C Cancellation of Debt. One copy goes to you and one copy goes to the IRS. This ensures that you don’t get out of paying taxes on that cancelled debt since it it considered income, as described above.
Use your 1099-C to fill out IRS Form 982, which is called Reduction of Tax Attributes Due to Discharge of Indebtedness.
IRS Form 982: Paying Taxes on Foreclosures and Repos
Getting foreclosed on your home is the equivalent to having a credit card company cancel you debt. Only the penalty is much worse since you lose your home. But the financial side of it is similar: you don’t owe the rest of your “bill”, or mortgage. But you do end up paying the lender some portion of the original amount: what you’ve already paid on your mortgage.
Again, you will be issued a 1099-C and so will the IRS. There are some exceptions to the tax rule: if the foreclosure was on your principle residence then you probably won’t pay any income tax for a foreclosure. Also, if you are declared insolvent then taxes are not levied on your cancelled debt.
For more information on IRS Form 982 see the IRS website for that form here.