Cancellation of Debt - Taxable?

[Yardley CPA]

Client received 1099 C for cancelled debt regarding a vacation home.  After falling behind on the mortgage, client negotiated a "deed in lieu of foreclosure" for the amount of the remaining debt.  Client and bank agreed on the terms.  Bank ended up sending client a 1099 C for the amount.  Should this be considered taxable income?  I know there are some exclusions to 1099 C when it is not taxable as referenced below.  Not sure the situation I described falls under these exclusions though.  Your thoughts please!  Thank you.

https://www.irs.gov/taxtopics/tc431.html

EXCEPTIONS to Cancellation of Debt Income:

1. Amounts canceled as gifts, bequests, devises, or inheritances
2. Certain qualified student loans canceled under the loan provisions that the loans would be canceled if you work for a certain period of time in certain professions for a broad class of employers
3. Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, paid it
4. A qualified purchase price reduction given by the seller of property to the buyer
5. Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program

Amounts that meet the requirements for any of the following exclusions aren't included in income, even though they're cancellation of debt income.

EXCLUSIONS from Gross Income:

1. Debt canceled in a Title 11 bankruptcy case
2. Debt canceled during insolvency
3. Cancellation of qualified farm indebtedness
4. Cancellation of qualified real property business indebtedness
5. Cancellation of qualified principal residence indebtedness

[ILLMAS]

I had an attorney  once recommend  me a client for some  tax consulting, and if I remember  correctly  the individual  found  a better house for a cheaper price and negotiated for the bank to take over the house and sell it, they were  successful  and the bank was going to forgive a chuck of money.  Individual scenario  did not fall under any of those categories I told the client and attorney and they agreed.

[Jack from Ohio]

Cancelled debt on a second or vacation home IS taxable.

[Pacun]

Use option 2. Debt canceled during insolvency provided you can prove he was insolvent the day before the debt was forgiven.

[Yardley CPA]

As the client and I were discussing this situation, I was leaning heavily toward it being taxable.  With that said, I looked at the exclusions and saw that vacation homes were excluded, so it reaffirmed my thinking.  Pacun...would insolvency, in and of itself, allow for the exclusion?

 

Taxpayer had just gone through a divorce with two dependent children. 

 

in·sol·ven·cy

inˈsälvənsē/

noun

noun: insolvency; plural noun: insolvencies

1. the state of being insolvent; inability to pay one's debts.

[Pacun]

Yes.

Think about this: Let's say president Obama signed a law that required banks to use the FMV of houses and to forgive people the rest of the debt. You are not insolvent but the bank forgave you $20K. Are you going to pay any taxes if that was your primary home? NO. That's because each exclusion stands by itself and you don't need to be insolvent.

Have you done a credit card debt forgiveness in the past where the client didn't have to pay taxes? Let's say you have a client whose credit card banks forgave $50K. The clients is insolvent and those were personal credit cards used to travel around the world for fun. You will use option 2, correct? As long as the client is insolvent prior to the debt discharge, client doesn't have to pay taxes on debt forgiveness. AND the client doesn't need to file bankruptcy.

 

[Yardley CPA]

Thanks very much for the information.  It's much appreciated. 

[Crank]

6 hours ago, Pacun said:

Use option 2. Debt canceled during insolvency provided you can prove he was insolvent the day before the debt was forgiven.

I had a client go this route.  Had to gather all assets and liabilities to prove insolvency.  Darned if he wasnt.  Him and his wife made good income too.  Claimed she was a chronic spender.  Ouch!

[Terry D EA]

I agree, if you can prove insolvency then you client is insolvent and option 2 would apply.

[schirallicpa]

Every time I have used insolvency, the IRS has written back asking for a copy of the insolvency worksheet in the publication.  So you might want to keep that handy.  

[Jack from Ohio]

15 minutes ago, schirallicpa said:

Every time I have used insolvency, the IRS has written back asking for a copy of the insolvency worksheet in the publication.  So you might want to keep that handy.  

AND... They will want documentation of all the entries on the worksheet.  Every time I have told a client to be sure to have documentation for all debts and assets, they decided just to pay the tax...

[Roberts]

Offtopic - client received a 1099-C for a credit card writing off $4,500 in balance due.

Client tells me initially they hadn't made a payment on it in years but he was getting ready to pay it ALL off.

With the code given I told him it is highly unlikely they will ever ask for the money again and it's on his credit report as lost.

Now all of a sudden he's obsessed that the credit card company has screwed up his credit rating. His not making payments for years isn't applicable?