In the last part of this series, we covered the consumer side of bad debt charge-offs and how the IRS handles that from a tax perspective. Today I want to delve into the business side of bad debt charge-offs. This side of things is usually quite complex and hard to generalize but I will attempt to keep my “tax guru” side in check and you on board.

Business Not What It Used To Be?

Let’s assume that we’re talking about a business (Corporation or LLC that is treated as an S-Corp for tax purposes) that has been hit hard by the recession and has run out of money to pay its creditors. Typically in cases like this the business will notify creditors who will then turn around and liquidate the business assets in order to attempt to recoup at least part of the debt owed. Once that happens the business is faced with a balance plus late fees and interest to cover.

Many times business owners will be able to negotiate a settlement far under the remaining balance owed and once that agreed upon price has been paid, the business owner will generally feel they have taken care of everything and their ordeal is over. Hooray!

But Wait! There’s More!

It’s not exactly time to celebrate yet. Come tax season the, now former, business owner receives a 1099-C for the canceled debt and interest. Now what to do? At this point the business owner would be wise to contact their accounting professional who will review the situation and offer advice on how much of that total will actually be taxable.

Their accounting professional will be able to determine this number by assessing the net worth of the business (a negative number at this point), the fair market value of any remaining business assets, and the amount of the canceled debt among other factors. Whatever the balance is, if any, is the amount of taxable income the business owner would be liable for paying taxes on.

The business owner may also be entitled to an ordinary business loss equal to the difference between the fair market value of business assets that were auctioned off (or the canceled debt, if less) and the cost of the assets to the owner.

Call Now And Save

As always there are a hundred different variables that will affect the outcome of a scenario like this; this example is a highly simplified version used to provide a general understanding of the concept and should not be taken as de facto for all situations.

My goal is to provide fair warning to business owners with a loss that they WILL have to deal with charged off debts when it comes time to handle their taxes. I also want to point out that it isn’t nearly as awful as it might first seem and, with the help of a professional, your tax liability may be significantly reduced or even eliminated. So don’t ignore those 1099-Cs, if you do it will create an even bigger and more expensive mess to straighten out.

At first, it may not make sense that the IRS would be concerned with a debtor’s written off debt. But the tax code is quite clear in stating that (under many circumstances) discharged debt is considered taxable income. This fact may leave you scratching your head and saying to yourself, “What?!? If I don’t have the money to pay off my debts, then how can I pay income taxes on my discharged debt? It makes no sense to me!”

Those who exploit tax code loopholes make it harder on everyone.

It is important to realize the tax code is written by very educated individuals that are trying to prevent abuses by a minority of unscrupulous taxpayers. Of course, the honest taxpayer must suffer in the process. The reasoning behind this seemingly silly tax law actually makes some sense (in theory).

For example, I borrow $10,000 from my local bank to go on a week-long luxury vacation to Italy. After having a grand time enjoying the excellent food, wine & culture I come back home with a full belly and empty pockets. In fact my pockets are so empty that I don’t have any money to pay off my bank debt. Eventually, the bank decides that it will not be able to collect on my loan and thus writes it off the debt from their loan portfolio (and their tax return).

The way the IRS sees it, the bank gave you $10,000 tax-free and the bank also took a tax deduction. So you benefit, and in some way the bank benefits. The IRS sees that as being unfair…to the IRS! Not surprisingly, there are those out there who would take advantage of such a loophole in order to disguise otherwise taxable income as tax-free discharged debt. Thanks to them, this code had to be created with provisions to close this loophole.

Unfortunately, in practice, this tax law adversely affects the honest taxpayers. If an honest taxpayer can’t pay their debts due to job loss or illness, then why should they be put into the same group as a dishonest taxpayer and be forced to pay income tax on discharged debt?

The good news is that Congress has attempted to help the honest taxpayer by creating several exceptions to recognizing discharged debt as income. The bad news is these exceptions are limited in scope and in some instances may only delay income recognition to a future date.

Tune in next week as the saga continues…

Foreclosure may seem like the end of the road, but wait! There's more!

Let’s break it down and see how this plays out: A homeowner purchased a house back in 1999 for $100,000 ($10,000 down and a $90,000 mortgage). Over time, the price of the house increased substantially until, in 2005, the house was worth $250,000. That same year, the owner established a home equity line of credit and subsequently borrowed $50,000. The loan proceeds were used to pay off credit cards, medical bills, and a car loan.

Unfortunately, the homeowner was laid off in 2008 and could no longer make the mortgage and home equity payments. During the same time, the value of the house dropped to $120,000, yet the total balance of the mortgage and home equity loan was $135,000. This leaves the homeowner owing $15,000 in cash in order to sell the home. Since the homeowner was unemployed and had little to no savings, selling the house was not a feasible option.

After several months of missed loan payments, the bank foreclosed and took possession of the home. Shortly thereafter, the bank sold the house at auction for $120,000. Since the sale price for the house could not cover the total loan balance and the home owner was unemployed, the bank decided to cancel the remaining unpaid balance of $15,000.

Seems like “problem solved” for the homeowner, right? Not quite.

Using a worst-case scenario, the homeowner who is unemployed and lost their home to foreclosure would have to pay an additional $5,250 in income taxes.

In this situation, there are two separate tax calculations: cancellation of debt and abandonment of property due to foreclosure. To simplify matters we’ll only be looking at the abandonment of property in detail.

When a bank forecloses on the property the homeowner will receive a 1099-A (along with a 1099-C, if applicable). The 1009-A will show the outstanding loan balance and the home’s fair market value when foreclosure occurred. For tax purposes, the foreclosure is treated as sale with any gain or loss. In this example, the gain on abandonment is $20,000 ($120,000 fair market value less $100,000 basis). Assuming the homeowner meets primary home exclusion (discussed in my last blog), the gain would not be taxable. If the homeowner did not meet the exclusion, an ordinary gain of $20,000 would be included on homeowner’s tax return.

Again, let’s assume the homeowner is in the 15% tax bracket for this particular year and had to include the $20,000 as income. The foreclosure would cost the homeowner an additional $3,000 in taxes. Let’s not forget the potential for additional income tax due to cancellation of debt. Assuming the canceled debt of $15,000 could not be excluded from taxes, the taxable income would increase by that amount which would result in an additional $2,250 of income tax ($15,000 x 15% tax rate). Using a worst-case scenario, the homeowner who is unemployed and lost their home to foreclosure would have to pay an additional $5,250 in income taxes.

I should point out here that many foreclosed home owners will not fall under this worst-case scenario since tax laws have certain protections for primary residence homes. However, there are no protections in place for owners of foreclosed rental real estate properties.

If you find yourself one of the millions of Americans facing this kind of situation I would definitely recommend seeking the advice of a reputable Accountant. The tax laws related to foreclosed real estate property are very complicated and shouldn’t be taken lightly or ignored. The IRS doesn’t accept ignorance as an excuse and won’t be likely to offer any leniency in such cases so be proactive, get good advice and avoid taking your situation from bad to worse.

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_{Fred Daus is the Chief Executive Officer and founder of Fredrick James Accounting, Tax & Consulting. He is a member of National Society of Accountants and the National Society of Tax Professionals and has been helping clients save money since 2001. Fredrick James is an innovative, full service accounting firm in Clearwater, Florida with a focus on providing outstanding service, tax savings and financial growth to clients in the Tampa Bay area and Nationwide. Visit our website www.FredrickJames.com or call 727-230-0716 for more information.}

_{U.S. Treasury Department Circular 230 Disclosure: In accordance with applicable professional regulations, please understand that, unless specifically stated otherwise, any written advice contained in, forwarded with, or attached to this communication is not a tax opinion and is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue code. The information provided on this blog is not intended to provide or be a substitute for specific individualized accounting, tax, legal, business, or investment planning advice. Where specific advice is necessary or appropriate, Fredrick James, LLC recommends consultation with a qualified Accountant, Tax Advisor, Lawyer, Financial Planner or Investment Manager. The information provided herein is for general informational purposes only and should not be considered an individualized recommendation, personalized investment advice or an endorsement by Fredrick James, LLC. The information presented is prepared for a general overview of subject matter; however, its accuracy, completeness or reliability cannot be guaranteed and therefore should not be relied upon as such. Fredrick James, LLC accepts no liability for any direct or consequential loss arising from any use of this information.}

Obviously this isn’t going to be the sunniest blog I’ve posted, but my hope is that readers can use the knowledge I’m sharing to empower themselves; an important step toward starting the financial and emotional recovery process.

The reality is that financially stressed homeowners can’t afford their homes and they can’t sell them which forces them into dramatically dropping their asking price, incurring a significant loss, or relinquishing their homes via foreclosure. Regardless of buying trends, in many cases, the home’s current market value isn’t even sufficient to cover the outstanding mortgage balance, causing lenders to write-off the amount of unpaid mortgage balance.

Here’s where things can go seriously wrong. Many individuals are completely unaware of the income tax consequences associated with distressed home ownership and may be shocked to find out they own thousands of dollars come tax season.

I know what you’re thinking, how is this possible? Well, here’s how it works: When a lender writes-off a loan balance (either partial or in whole), they are required to issue a Form 1099-C for the amount of the write-off to the borrower. This applies to any type of loan (auto, mortgage, credit card, etc.). Generally, the write-off amount is recognized as taxable income on the borrower’s tax return. For example, if a credit card company writes-off a $10,000 balance, then a Form 1099-C will be issued for the amount. Now let’s assume the borrower receiving the Form 1099-C is in the 15% tax bracket. The borrower will have an additional $1,500 in taxes due ($10,000 x 15%). So now, the borrower (who’s broke, mind you) has to come up with $1,500 to pay these taxes. Are you seeing the “catch 22” going on here? What is the borrower supposed to do, charge the tax on a credit card? If this situation is bad enough, imagine a mortgage write-off!

Fortunately the government isn’t a completely heartless entity, despite appearances. When foreclosures started to accelerate a couple of years ago, Congress enacted tax law changes to exclude from taxable income, debt write-offs associated with a taxpayer’s primary home. It is important to remember this ONLY applies to mortgages used to purchase or improve a primary home. It DOES NOT apply to other types of loans such as automobile loans, credit cards, and home loans NOT used to purchase or improve a primary residence. Unfortunately, these other loan write-offs will generally continue to be taxable income. However, there are some additional exceptions to inclusion of canceled debt as taxable income.

While there’s really just a glimmer of a silver lining here, for homeowners caught in this turbulent situation, any relief is welcome when it feels like their world has been turned upside down.

Although I’ve broken down the basic concept of one aspect of income tax exclusion for some cancelled debts, the many tax laws associated with any cancelled debt are very complicated. Distressed homeowners and others facing loan and credit card write-offs can save themselves more stress and unexpected tax bills by seeking competent advice from an accountant who will steer them clear of any further disasters.

Come back next week for part two when we’ll discuss another tax consequence related specifically to home foreclosures. In the mean time, feel free to leave your comments and let us know about your situation.

_{Fred Daus is the Chief Executive Officer and founder of Fredrick James Accounting, Tax & Consulting. He is a member of National Society of Accountants and the National Society of Tax Professionals and has been helping clients save money since 2001. Fredrick James is an innovative, full service accounting firm in Clearwater, Florida with a focus on providing outstanding service, tax savings and financial growth to clients in the Tampa Bay area and Nationwide. Visit our website www.FredrickJames.com or call 727-230-0716 for more information.}

_{U.S. Treasury Department Circular 230 Disclosure: In accordance with applicable professional regulations, please understand that, unless specifically stated otherwise, any written advice contained in, forwarded with, or attached to this communication is not a tax opinion and is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue code. The information provided on this blog is not intended to provide or be a substitute for specific individualized accounting, tax, legal, business, or investment planning advice. Where specific advice is necessary or appropriate, Fredrick James, LLC recommends consultation with a qualified Accountant, Tax Advisor, Lawyer, Financial Planner or Investment Manager. The information provided herein is for general informational purposes only and should not be considered an individualized recommendation, personalized investment advice or an endorsement by Fredrick James, LLC. The information presented is prepared for a general overview of subject matter; however, its accuracy, completeness or reliability cannot be guaranteed and therefore should not be relied upon as such. Fredrick James, LLC accepts no liability for any direct or consequential loss arising from any use of this information.}