Congress Extends the Income Exclusion for 1099 ‘Forgiven’ Mortgage Debt to Tax Years 2015 and 2016

For a more detailed discussion on tax debt and other tax resolution issues, be sure to read Wartchow Law’s Tax Blog.

On December 18, 2015, Congress extended certain tax breaks to apply for both tax years 2015 and 2016, including the income exclusion for forgiven mortgage debt on a qualified principal residence. “Forgiven” or “cancelled” mortgage debt on a Form 1099-C occurs usually after a homestead is foreclosed, short sold or otherwise a defaulted mortgage goes unpaid for the statutory period of time. Upon the occurrence of these events, banks are required to treat the unpaid balance as “forgiven” and issue a Form 1099-C to the homeowner for the balance that is cancelled. (The term “forgiven” is a gross misnomer since, in fact, the mortgage balance remains lawfully collectible in full—more on that later in this article).

As of October 20, 2015, the Mortgage Debt Relief Act had not yet been extended to tax year 2015. However since President Obama approved an extension of the tax relief for the next two tax years (i.e., 2015 and 2016), this means that homeowners receiving a 1099 for mortgage debt will not be required to declare mortgage debt as taxable income on their federal income tax return. In past years, Congress has typically waited until December to extend the Act’s tax relief to homeowners (better last minute than never).

The Internal Revenue Service and state taxing authorities treat the 1099’d mortgage debt as taxable income unless an exclusion is claimed by the taxpayer on Form 982 for the tax year for which the 1099 is issued. This means that a 1099 received on even a mortgage balance of $30,000, for example, can result in significant federal and state income tax liability upwards of $5,000 or more for just a middle-income taxpayer. For higher income earners, this 1099 could result in massive tax consequences into the tens of thousands. The exclusion operates to exclude the 1099 from taxable income if the amount forgiven was “qualified principal residence indebtedness”. For current information on this and other income exclusions, see IRS Publication 4681.

This income tax exclusion for forgiven mortgage debt dates back to 2007 and Congress’s then-response to overwhelming consumer need for protection against tax liability contained in the Mortgage Foreclosure Debt Forgiveness Act. This most recent bill passing by Congress now allows for homeowners to claim the income exclusion on their 2015 and 2016 tax returns (assuming the 1099-C is issued for 2015 or 2016).

Tax year 2017 is currently without any extension of the mortgage debt income exclusion–look for that decision to be before Congress in December 2017. Other income exclusions may still be available however, for example the insolvency exclusion or the exclusion for a discharge received in bankruptcy.

This income tax “relief” for forgiven mortgage debt is not to be taken without a heaping measure of caution, however.

First, a 1099 does not actually denote that the mortgage balance forgiven and, in fact, the homeowner still owes the entire amount to the bank which can be collected upon via lawsuit and other means. Wait, back that up. The bank declares the mortgage forgiven and takes their tax benefit, the homeowner is personally responsible for the resulting income tax on the forgiven amount, but yet the homeowner can STILL be held accountable for the mortgage balance owed? Yes, actually. Practically, this means that the bank may still lawfully report the entire balance as due, owing and in default on a homeowner’s credit report, potentially ruining their credit. More significantly, perhaps, this also means that a homeowner can be sued for the forgiven balance and, if judgment is obtained, their wages garnished and bank account levied.

There are many state courts around the country—including here in Minnesota—that have declared that issuance of a Form 1099-C does not alone operate to legally extinguish a debt and, therefore, the full balance remains outstanding absent some operation of the law, such as a discharge received in a bankruptcy proceeding. These courts rely on an IRS Information Letter dated December 30, 2005, which explained: “The Internal Revenue Service does not view a Form 1099-C as an admission by the creditor that it has discharged the debt and can no longer pursue collection.” See I.R.S. Info. 2005-0207, 2005 WL 3561135 (Dec. 30, 2005). How’s that for deceptive wording?

Second, the timing of asserting the exclusion on your income tax return is tight to say the least. Assuming a homeowner timely receives the 1099-C following the end of the tax year for which it is issued, they still have time to report the income and claim the exclusion via IRS Form 982. But for homeowners who did not timely receive the 1099-C from the bank, the deadline to amend their tax return to claim the exclusion is six months from the date the return was originally due, which is usually April 15th of the following year. As an illustration, if a homeowner was in an active bankruptcy proceeding when the bank declared the mortgage forgiven on a home foreclosed prior to filing bankruptcy, the bank may have issued a 1099-C to the IRS yet simply never sent the 1099-C to the homeowner due to their being in bankruptcy at the time (or instead of bankruptcy, perhaps the 1099 was lost in the mail or the bank sent it to the wrong address). In this example, the homeowner may not find out about the 1099-C until years later when the IRS sends a collection letter for the additional income tax due on the forgiven mortgage—and all in spite of the bankruptcy. The result is that the homeowner is outside of the 6-month deadline for amending their 2013 tax returns to claim the income exclusion and is now strapped with the additional tax debt and a battle against both the bank and the Internal Revenue Service. Try unwinding that tax debacle.

For more about 1099s and the insolvency exclusion, see Received a Form 1099-C on Foreclosed Home? You May Qualify for the Mortgage Forgiveness Exclusion to Cancellation of Debt Income.

Received a 1099-Misc on Cancelled Debt? You May Qualify for Exclusion from Taxes if You Were Insolvent or Filed Bankruptcy

Generally, when a debt is owed and at least $600 of the debt is canceled, forgiven or settled for less than the full amount owed, this amount forgiven is treated for income for tax purposes. Cancelled debts often arise after a home is foreclosed with a deficiency still owed. Cancelled debts also occur when a credit card goes unpaid for the statutory period or the balance is settled for less than the full balance owed. In these common cases, the person receiving the benefit of the debt cancellation may receive a Form 1099-C or 1099-Misc., requiring them to report income and possibly also pay income tax on the amount forgiven/cancelled.

For a more detailed discussion on tax debt and other tax resolution issues, be sure to read Wartchow Law’s Tax Blog.

Cancelled debts are reported on a Form 1099 and not always in the year that the debt is cancelled. Form 1099s can be sent up to three years after the debt was cancelled, which may result in your having to amend that year’s tax returns. Once reported on a 1099, you are required by law to report this income on your tax returns and both the IRS and state includes the amount of cancelled debt as taxable income. Accordingly, this additional taxable income may result in taxes owed at the same rate that income is taxed.

However, there are exceptions to being taxed on cancelled or forgiven debt if you were insolvent immediately before the debt was cancelled or otherwise if you received a discharge in a Chapter 7 or Chapter 13 bankruptcy proceeding. While both insolvency and a discharge in a bankruptcy proceeding may provide an exception for some types of cancelled debts (particularly regarding residential mortgages), insolvency by the IRS standards does not require that you actually file bankruptcy. You can be insolvent according to the IRS without actually filing bankruptcy. If you qualify as “insolvent” according to the IRS standards, you must still report the Form 1099. income on your tax returns however you can separately file Form 982 is you qualify to exclude this income from your taxable income

A common example of cancelled debt is when a credit card balance is settled for less than the full amount owed, thus resulting in an amount which is “forgiven” or cancelled by the credit card company. Under federal law, the credit card company is required to report the amount of the cancelled debt as taxable income to the credit card holder.

As another example, if a personal vehicle was repossessed and then later sold by the lender after repossession, the amount owed on the loan would be reduced by the sale proceeds however usually a “deficiency” is still be owed. In this case, your lender may send you a 1099 for the difference owed which is “cancelled” by them. Unless you file bankruptcy or were insolvent immediately before the cancellation of the deficiency, you may owe income tax on that deficiency.

You should not receive a Form 1099 on debs that were previously discharged in a bankruptcy occurring prior to the issuance of the 1099. In fact, bankruptcy is usually an all-inclusive exclusion from taxes for cancelled debts, however you must still report the 1099 income on Form 982 and attach to your federal tax return. Note that the IRS Form 982 refers to a bankruptcy discharge as a “discharge of indebtedness in a title 11 case” since the Bankruptcy Code is under title 11 of the United States Code.

More information on the taxation of cancelled debts is available at www.IRS.gov and in the IRS Publication 4681.

Also see Received a Form 1099 on Foreclosed Home? You May Qualify for the Mortgage Forgiveness Exclusion to Cancellation of Debt Income.

Located in Edina, Minnesota, attorney Lynn Wartchow represents clients in all Chapters of bankruptcy in Minneapolis, St. Paul, Ramsey and Hennepin County, and throughout Minnesota.

 

How Are Non-Dischargeable Debts Treated in a Chapter 13 Bankruptcy?

Non-dischargeable debts are those few categories of personal liabilities which can never be discharged in either form of Chapter 7 or Chapter 13 bankruptcy. Non-dischargeable debts include most individual income taxes, many business-related taxes such as withholding tax and other trust fund taxes, domestic support obligations, spousal support/alimony and child support, debts related to fraud or fiduciary embezzlement, educational and student loans, unlisted debts and other less common types of debts. (Note that some divorce decree obligations may be dischargeable in Chapter 13.)

One of the great benefits of Chapter 13 over Chapter 7 is that certain non-dischargeable debts can be paid back over time in Chapter 13 plan, usually over five years, which can maximize a Chapter 13 debtor’s cash flow and repayment flexibility. For example in Chapter 13, you can stretch out repayment of priority debts—such as income taxes—over five years versus the standard two to three years the taxing authorities typically require outside of bankruptcy.

It’s important to note that most taxes, domestic support obligations and mortgage arrearages must be repaid in full through the Chapter 13 plan. Practically speaking, this means that the debtor’s budget must demonstrate that they afford the minimum monthly repayment required in order to repay the non-dischargeable over sixty months (in a five year plan).  Your Chapter 13 attorney can help you calculate whether repayment of the non-dischargeable debts is feasible considering your monthly income and expenses.

The flexibility of time in repaying the few categories of non-dischargeable debts is a distinct advantage to Chapter 13. Whether a debt is discharged in bankruptcy is often fact-specific and you should seek the advice of an attorney for more information specific to your circumstances.

Wartchow Law Office advises clients in Minnesota on how Chapter 13 bankruptcy can provide relief and what they can expect from a Chapter 13 plan.  Contact for a free consultation and more information on options available under Chapter 13 bankruptcy. Located in Edina, Minnesota.

 

 

Received a Form 1099-C on Foreclosed Home? You May Qualify for the Mortgage Forgiveness Exclusion to Cancellation of Debt Income.

If you receive a Form 1099-C reporting ‘debt cancellation’ income after a home foreclosure, you may qualify for the Mortgage Forgiveness exclusion. As if the distress of home foreclosure isn’t enough, homeowners may receive a Form 1099-C from their former mortgage lender reporting the deficiency owed as income to the homeowner. The income reported on the Form 1099-C is what’s referred to as “Cancellation of Debt Income” or “Discharge of Indebtedness Income”, both of which generally must be reported as taxable income on an individual’s Form 1040 federal and state tax returns. When the 1099 relates to foreclosed real estate, the amount of cancelled debt can be significant and can consequently result in a substantial increase in tax liability for that year, loss of tax refunds or even additional tax liabilities owed to the IRS and Minnesota Department of Revenue.

For a more detailed discussion on tax debt and other tax resolution issues, be sure to read Wartchow Law’s Tax Blog.

Typically, cancellation of debt is an income realization event that must be reported on one’s tax returns. The idea is that any amount of principal or interest that a person legally owes but does not have to repay is considered taxable income in the year that such debt is cancelled. As an illustration, if you owe a commercial lender $15,000 between interest and principal due on a loan but that creditor agrees to accept $5,000 and cancel the other $10,000 in satisfaction of the full amount, that creditor is required by federal law to issue an IRS Form 1099-C, which reports the $10,000 cancelled debt as taxable income to you. Depending on the circumstances, the amount reported on Form 1099 must be included as personal income unless a statutory exclusion applies. Most of the IRS’s income exclusions are conditioned upon insolvency of the taxpayer—i.e., total debts exceed total fair market value of all assets—however bankruptcy is not necessarily required to qualify under certain IRS insolvency exclusions. Even in the absence of insolvency, a homeowner may still qualify for the Mortgage Forgiveness exclusion.

The Mortgage Forgiveness exclusion is provided under the Mortgage Debt Relief Act of 2007, which allows most taxpayers to exclude 1099 income resulting from the discharge of debt on their principal residence. The key to qualifying for this exclusion is that the debt must have been incurred to buy, build or substantially improve your principal residence and the debt must have been secured by your principal residence. Most traditional mortgages on homestead properties would meet this criteria. Currently, the Mortgage Debt Relief Act only applies through 2012, after which it may be extended by additional act of Congress.

When an individual files for bankruptcy, Section 108 of the Internal Revenue Code automatically excludes any debt that was discharged in the bankruptcy from taxable income. This is why consumer debtors who receive a discharge in a Chapter 7 or Chapter 13 bankruptcy proceeding rarely receive a 1099 regarding any of the discharged debts (and if you do, you should talk to your tax preparer about your options to dispute the 1099).

Wartchow Law Office is a law firm located in Edina, Minnesota with  an exclusive practice in Chapter 7, Chapter 13 and Chapter 11 bankruptcy law,  representing individual consumer and business clients throughout the Twin Cities of Minneapolis and St. Paul, Minnesota.

For more information on The Mortgage Forgiveness Debt Relief Act and Debt Cancellation, see IRS Publication 4681 and IRS Form 982 available on the IRS website at www.irs.gov. You should always ask your tax professional for tax advice and not rely on information found online. This information is intended for entertainment purposes only and use of any information from this site or any other web site referred to is for general information only and does not represent personal tax advice either express or implied. You are encouraged to seek professional tax advice for personal income tax questions and assistance.  

Sales Tax Obligations and Chapter 11 Business Reorganization

Minnesota Department of Revenue levies sales tax on any number of transactions common to small businesses, most often being on sales of taxable goods and services. Sales tax is considered a “trust” tax, as it is collected by the retailer and must be held in trust for the State until remitted on the appropriate due date. Responsibility for paying sales tax falls not only on the business but also at times on the company’s principals.

Since the sales tax money collected never actually belongs to the business, use of the tax money for any purpose other than direct remittance to the State is expressly  disallowed. In practice, however, it is common for businesses to merge the sales taxes collected with its own operating funds, thus at times risking that some of the taxes may be used to cash flow general operating expenses rather than remittance to the State. When this happens and a business cannot timely remit the sales tax to the State, the domino effect happens quickly and can be synonymous with the end of business operations. For retailers, non-payment of sales tax obligations means their sales tax vendor permit may be quickly revoked. Once revoked, no more sales are allowed. For a business such as a restaurant or bar, their liquor license additionally can be posted and the business prevented from further purchases of liquor, wine and beer inventory.

When past due sales tax is the problem, Chapter 11 can leverage certain relief that  may not otherwise be available to the small business in a non-bankruptcy context.  Specifically in Chapter 11 business reorganization, past due sales taxes can be statutorily repaid over five years at low interest, and under some circumstances sales tax permits and liquor licenses can be reinstated while personal collection may also be stalled to allow time for the business to reemerge with a confirmed Chapter 11 plan.

While a multitude of factors should be considered before filing Chapter 11 business reorganization, the repayment of sales tax obligations over five years that is prescribed by the Bankruptcy Code can offer significant relief that may not otherwise be available without a bankruptcy filing. Sales tax is just one example of the various circumstances that often lead to Chapter 11 bankruptcy.

Contact Chapter 11 attorney Lynn Wartchow for an initial Chapter 11 consultation to review tax and other business liabilities affecting a Chapter 11 bankruptcy proceeding. Office located in Edina, Minnesota.

When sales tax threatens a business: Chapter 11 may be the answer

When I became aware of a popular local restaurant and bar recently close its doors due to unpaid sales tax and subsequent state shutdown, I had to wonder why no one suggested that the owners file a Chapter 11 business reorganization. True, I cannot be sure that the owners did not consult an attorney and make the decision not to file Chapter 11, but I have my doubts. The establishment was a long-standing popular Minneapolis hotspot, overflowing with patrons bursting out the doors even on weeknights—how could they not be making a decent profit? The zoning of the neighborhood may be to blame, which dictates a mandatory portion of receipts must be from food rather than alcohol, or the sales tax and penalties spike. Here in Minnesota, if a business that sells alcohol is delinquent in paying its sales tax, it can expect to have its liquor license posted within a month. Once a liquor license is posted, the business is not allowed to purchase liquor from wholesalers and distributors until they pay the tax in full, thereby leaving the business with a dwindling supply of inventory to sell to the public while it tries to generate enough revenue to pay the tax bill. Unlike other types of creditors that may be more negotiable, the state’s taxing authority is an unyielding force of government that demands payment under the threat of immediate adverse action. With the Minnesota Department of Revenue, you have to pay to play, and if you want to run a bar, you better pay your sales tax on time each month.

With one not-so-obvious exception: Chapter 11 business reorganization. While this means a business must file for bankruptcy, bankruptcy doesn’t necessarily mean it will go out of business. Quite the opposite—Chapter 11 is a mechanism established under federal law that provides significant flexibility for businesses to reorganize any number of liabilities so long as they can achieve future cash flow to actually stay in business. First and foremost, from the moment the Chapter 11 is filed, the state cannot post the liquor license—this is why it’s so important to head off the posting ideally before it happens. As for resolving the unpaid sales tax bill, the Bankruptcy Code generously allows businesses five years to repay federal and state tax liabilities. A five-year tax repayment plan sure beats the one month notice of liquor license posting.

Of course, other debts can also be reorganized in Chapter 11. Unsecured debt may be reduced to a fraction and paid over time while secured debts and financing agreements may likewise be restructured over more time with principal and interest reduced, and any other number of issues are given more flexibility inside a Chapter 11 bankruptcy proceeding. It should go without saying that, just as with most everything in life, it’s best to explore the bankruptcy option as early as possible and get an idea of what Chapter 11 may look like under your business’s specific circumstances.

The best general advice for a restaurant or bar struggling under sales tax liability: Talk to an attorney that does Chapter 11, and ideally before things go from bad to worse. Even if “bankruptcy” has not been part of your vocabulary before, it could be the solution that keeps your doors open and gets your business back in the black. As for the local favorite restaurant and bar I mentioned earlier in this post, I wish we had met sooner and hope you reopen soon.

Keep reading for more information about Sales Tax Obligations and Chapter 11 Business Reorganization.

Attorney Lynn Wartchow has represented Chapter 11 business reorganizations proceedings involving restaurants, bars, nightclubs and other businesses in Minneapolis since 2008.