The IRS treats canceled debt as income. This means that when a creditor cancels or forgives debt the amount of the canceled or forgiven debt is treated as income to the person forgiven.
For example, if you and spouse settled joint credit card debt for less than the amount owed you will receive a 1099 reflecting the amount forgiven. Similarly, if you sell your home as a short sale, sign a deed in lieu of foreclosure, or have your home foreclosed upon you may receive a 1099 for the amount of the debt that was forgiven.
The following example will help illustrate how canceled debt operates in the context of a short sale. If a husband and wife sell their house at a short sale for $385,000 but they owe $485,000 on the mortgage, the canceled debt is $100,000. While the bank is forgiving the $100,000 shortfall, the IRS is treating the $100,000 canceled debt as income to the husband and wife. The IRS learns about the canceled debt because the bank sends you and the IRS a Form 1099 which reports the amount of canceled debt. Having received the Form 1099 notice of canceled debt from the bank, the IRS is expecting you to report and pay taxes on that canceled debt.
To summarize, in the context of your divorce if you and your spouse are settling credit card debt, selling your home at a short sale, or your home is going into foreclosure, you should be aware that you may have to deal with the tax consequences of the canceled debt income on the back end.
Mortgage Debt Forgiveness Relief Act
In response to the 2008 mortgage foreclosure crisis Congress enacted the Mortgage Debt Forgiveness Relief Act which had the effect of sparing foreclosed on homeowners, and homeowners who short sold their homes from having to pay taxes on canceled debt income. Unfortunately the act expired in December 2013 and has not been renewed. The effect of the Act’s expiration has been renewed exposure for homeowner’s who have their loans forgiven or canceled by their bank after a short sale, deed in lieu of foreclosure, or foreclosure.
One way for the divorcing parties to avoid the tax consequences of canceled debt income is to complete the IRS’ insolvency worksheet. If the party’s are insolvent there may be no canceled debt income. A person is insolvent when the total value of their assets is less than the total value of their liabilities or debts. The IRS worksheet guides you in listing your assets, their values, and your liabilities. If you are determined to be insolvent the canceled debt income is not taxable.
Allocating Canceled Debt Income Between Divorcing Spouses
If you foresee potential issues with canceled debt income your marital settlement agreement will have to contain language which deals specifically and in detail with this issue. The 1099 for the canceled debt will be issued in the name of the account holder. If all of the settled/canceled debt is in your name the IRS will be looking to you solely to pay the taxes on the income. For example, if you and your spouse have a credit card that you both used during the marriage and after the card was settled you received a 1099 from the settling creditor, only you will be responsible for paying the taxes due on that phantom income. Post-divorce you cannot file taxes jointly, or even as married filing separately. If this is an issue in your divorce it needs to be dealt with prior to the finalization of the divorce paperwork.
If you are going through a divorce and you anticipate that you will have canceled debt income don’t hesitate to contact me at 201-731-3086, or via e-mail using the contact form. I have been helping clients resolve issues involving debt and transfer of their marital home for over 20 years. My practice operates principally in northern New Jersey in Bergen, Essex, Hudson, Passaic and Union counties. The consultation is free.